What is a liquidity pool?
A liquidity pool is a smart contract which contains a reserve of two or more cryptocurrency chips in a decentralized exchange (DEX). Liquidity pools encourage investors to earn passive income on cryptocurrencies that would otherwise go unused.
The exact procedure for joining a liquidity pool can vary depending on the platform, but the process generally involves creating an account on a decentralized finance (DeFi), connecting a Ethereum Wallet into the account and depositing two different types of tokens into the platform pool to form a trading pair. (Most liquidity pools require cryptocurrencies to be deposited in pairs of equal value.)
What Liquidity Pools Do
Liquidity pools allow buyers and sellers of cryptocurrencies to trade tokens on a DEX without the need for a centralized order book or traditional market maker. Instead, all trading activities are managed by the smart contract that controls the pool.
Automated Market Maker The contract’s (AMM) algorithms determine the price of each token and adjust prices in real time based on supply and demand. This ensures that the supply of each token in a pool is always proportional to the other tokens in the pool.
Investors who add their tokens to the pool receive a share of the exchange’s trading fees or other investment incentive. The value of the incentive earned is proportional to the amount of liquidity provided by the investor.
History of Liquidity Pools
In the early phases of DeFi, decentralized exchanges used traditional bank order books to match buyers and sellers. This approach was problematic for several reasons:
- Order books required significant computing power to match buyers and sellers, and the process was slow.
- High gas fees made it difficult for small traders to participate in the market.
- Traditional order books are vulnerable to front-running. Users with faster connections could see and execute transactions before users with slower connections.
In 2017, the co-founders of Bancor Network found a way to counter these problems by executing trades against the liquidity of a pool of crowdsourced assets. This change alone is considered responsible for the rapid growth of DeFi.
The importance of liquidity pools
Liquidity pools play an important role in blockchain borrow-lend protocols, yield farmingon-chain insurance and gaming protocols.
Traditional finance (TradFi) must match a buyer with a seller before a transaction can be completed. In contrast, DeFi platforms can automatically execute a transaction against the liquidity of the platform pool.
This is important because it means DeFi platforms do not need to match the expected price of a transaction with the executed price. If the executed price of the transaction is higher than the expected price, the buyer will simply receive fewer tokens than expected and the seller will receive more tokens. This is called slippage.
To offset potential losses caused by slippage, the pool charges a small fee for each transaction and distributes the fees among liquidity providers in a ratio proportional to their share in the pool.
Total value locked
DeFi liquidity is generally expressed in terms of total value locked (TVL). TVL represents the total value of assets locked on a particular DeFi platform. Typically, this includes the amount of cryptocurrency locked in smart contracts, as well as any other assets the platform has tokenized.
TVL is an important metric for DeFi protocols because it provides investors with an indication of a platform’s overall liquidity.
Platforms with higher TVL are generally considered to have greater growth potential than platforms with lower TVL.
Risks
Although liquid asset pools offer users the opportunity to earn yield on crypto that would otherwise go unused, using them to generate passive income also carries risks.
- Once assets are added to a liquidity pool, they are controlled by a smart contract. If a malicious actor gains access to a smart contract that controls a liquidity pool, they may be able to steal all of the funds in the pool.
- If smart contract developers allow themselves to change the rules governing the pool, there is always a risk that the developer will manipulate the contract for their own benefit by changing the fee structure, token ratio, or other key parameters of the pool. pool.
- If the ratio of tokens in a liquidity pool becomes unequal due to large price changes, the liquidity provider (LP) could face permanent sanctions and fleeting loss of their invested assets.
It is important that investors are aware of the risks and take appropriate steps to protect their investments. This includes doing your due diligence before investing in a pool.
Best practices
Before investing in a pool, liquidity providers should thoroughly research the platform in question and the pool itself.
Best practices for ensuring that a pool’s liquidity rules are fair and predictable and that the interests of liquidity providers are protected include:
- Look for pools that have high trading volume and significant liquidity;
- Check if the liquidity pool is backed by strong developer community and has an active user base;
- Platform Team Verification credentials;
- Read team white papers and website content;
- Search for reviews from other users;
- Ensure that the liquidity pool has a transparent governance structure and decision-making processes;
- Looking for evidence that the pool has undergone independent safety audits.
Popular Liquidity Pools
Today, many decentralized platforms use liquid asset pools to trade digital assets in an automated and permissionless manner. Popular platforms that center their operations on liquidity pools include:
Uniswap: Uniswap is a decentralized exchange that runs on Ethereum blockchain and allows users to trade any ERC-20 token. Uniswap has several liquidity pools. Some of their most popular pools support ETH/USDT, ETH/DAI, and ETH/USDC trading.
Curve: Curve is a decentralized exchange specializing in stable coins and enables low slippage trading for assets of similar values. Curve has several liquidity pools. Some of their most popular pools support BTC/renBTC/wBTC/sBTC and USDT/USDC/DAI.
Pendulum: Balancer is a decentralized exchange that allows users to create custom liquidity pools with up to eight tokens. Some of the popular balancer pools include ETH/USDC/DAI/WBTC, WBTC/renBTC/sBTC, and LINK/ETH.
Sushi exchange: SushiSwap is a decentralized exchange that offers liquidity pools with high yield farming incentives for liquidity providers. Some of the most popular SushiSwap pools include ETH/USDC, ETH/USDT, and ETH/WBTC.
