WHAT IS A LIQUIDITY POOL AND HOW DOES IT WORK?

Liquidity pools are one of the most important technologies today.   Automated Market Makers (AMMs), borrow-loan procedures, yield farming, synthetic assets, and on-chain insurance all rely on them.

The concept is straightforward on its own. Liquidity pools are basically throwing funds in a big pile of numbers.  But what can you do with this pile of cash in a permissionless environment where anyone can add liquidity?

INTRODUCTION

Decentralized finance (DeFi) has sparked a flurry of activity on the blockchain. The number of DEXs can compete with the number of centralized exchanges in a substantial way. The DeFi protocol had almost $15 billion in value as of December 2020. The ecosystem is rapidly growing, with new product types appearing on a regular basis.

But what enables all of this expansion? Liquidity pools are one of the key technologies driving all of these products.

WHAT IS A LIQUIDITY POOL AND HOW DOES IT WORK?

A liquidity pool is a group of funds that have been locked in a smart contract. Liquidity pools are used to enable decentralized trading, lending, and a variety of other activities, which we will discuss later.

Many countries’ liquidity pools are their backbone. Unified Exchange is an example of a decentralized exchange (DEX). To form a market, users known as Liquidity Providers (LPs) combine two tokens of equal value in a pool. They remove funds from their accounts in exchange for giving funds. On transactions that take place in the pool, transaction fees are generated in proportion to their part of the total liquidity.

Because everyone can offer liquidity. AMMs make it easier to market.

Bancor was one of the first protocols to use liquidity pools, but the concept gained traction with the success of Uniswap. Sushi Exchange, Curve, and Balancer are are more notable Ethereum exchanges that use liquidity pools. ERC-20 coins are used in the liquidity pools on these exchanges. On the Binance Smart Chain (BSC), where the pool holds BEP-20 tokens, there are similar equivalents (pancake exchange, bakery exchange, and burger trade).

ORDER BOOKS AND LIQUIDITY POOLS

Let’s take a look at the order book, which is the most basic building block of electronic trading, to see how liquidity pools differ. An order book is just a collection of presently open orders for a specific market.

The matching engine is a method for matching orders against each other. The order book, together with the matching engine, is at the heart of any centralized exchange (CEX). This concept is particularly useful for supporting efficient exchanges and allowing sophisticated financial markets to be created.

DeFi transactions, on the other hand, entail conducting transactions on-chain without the funds being held by a centralized entity. When it comes to ordering books, this is a problem. Every interaction with the order book incurs a gas fee, greatly increasing the cost of trading.

It also increases the cost of market makers’ job (dealers that supply liquidity for trading pairs). Most blockchains, however, cannot handle the throughput required for billions of dollars in daily transactions.

This means that creating an order book exchange on a blockchain like Ethereum is essentially impossible. You can employ sidechains or layer 2 solutions, both of which are coming soon. However, in its current state, the network is incapable of handling such high traffic.

Before we proceed any further, it’s important mentioning that some DEXes operate well on order books that are on-chain. Binance DEX is based on the Binance Chain and is optimized for quick and low-cost transactions. Project Serum, which is being built on the Solana blockchain, is another example.

Even yet, because Ethereum hosts the majority of cryptocurrency assets, you won’t be able to trade on other networks unless you use a cross-chain bridge.

HOW DOES THE LIQUIDITY POOL WORKS?

AMMs (automated market makers) have altered the game. They are a significant advancement since they enable on-chain transactions without the use of an order book. Traders can enter and exit positions in token pairs that may be highly illiquid on order book exchanges because no direct counterparty is required to complete trades.

Order book exchanges are similar to peer-to-peer marketplaces in that they connect buyers and sellers through order books. On the Binance DEX, for example, transactions are peer-to-peer because they occur directly between users’ wallets.

Trading with AMM is a unique experience. Transactions on AMM can be thought of as peer-to-peer contracts.

A liquidity pool, as previously stated, is a collection of funds deposited into smart contracts by liquidity providers. You don’t have a counterparty in the usual sense when you trade on AMM. Rather, you place trades using liquidity from the liquidity pool. There does not need to be a selling for the buyer at that time; all that is required is sufficient liquidity in the pool.

There are no traditional retailers on the other side of Uniswap when you buy the latest food coins. Instead, what happens in the pool is guided by algorithms that control your activities. Furthermore, this algorithm determines price based on transactions that occur in the pool.

Of all, liquidity must come from someplace, and anyone can offer liquidity, so they can be considered your counterparty in some ways. However, because you’re interacting with the contract that controls the pool of cash, this isn’t the same as the order model.

WHAT PURPOSE DOES THE LIQUIDITY POOL SERVE?

So far, we’ve mostly talked about AMMs, which are the most common way to use liquidity pools. However, because pooling liquidity is such a basic notion, it may be applied in a variety of situations.

Yield farming, also known as liquidity mining, is one of them. Users contribute their assets to a liquidity pool, which is then used to produce yields, which is the foundation of automated yield generation systems.

For cryptocurrency initiatives, getting additional tokens to the proper individuals is a huge challenge. One of the most successful strategies has always been liquidity mining. To summarize, tokens are allocated to users who deposit their tokens into liquidity pools using an algorithm. After that, the freshly created tokens are divided equally to each user’s pool share.

Keep in mind that these can also be pool tokens from other liquidity pools. If you give liquidity to a unified exchange or lend money to a compound, for example, you will receive tokens in the pool share of tokens on your behalf. You might use these tokens to obtain rewards in another pool. As protocols integrate other protocols’ pool tokens into their goods, etc., these chains might get rather complex.

Governance might also be considered a use case. Before formal governance suggestions can be made, a high threshold for token voting may be required in some situations. Participants can unite behind a shared cause they believe is vital to the protocol if finances are pooled.

Insurance against smart contract risks is another emerging DeFi topic. Liquidity pools are also at the heart of many of its implementations.

Scribing is another cutting-edge application of liquidity pools. It’s a traditional finance concept that involves categorizing financial items based on risk and return. As you might anticipate, these services allow LPs to choose their own risk and reward profiles.

Liquidity pools are also used when creating synthetic assets on the blockchain. You can create a synthetic token pegged to any asset by adding some collateral to a liquidity pool and connecting it to a trustworthy oracle. In truth, the problem is more difficult than that, but the underlying concept is so easy.

What else can we come up with? Liquidity pools may have a variety of applications that have yet to be discovered, and it all depends on the creativity of DeFi developers.

RISK OF A LIQUIDITY POOL

If you lend money to AMM, you should be mindful of the concept of temporary loss. In short, providing liquidity to an AMM results in a dollar loss as compared to HODLing.

You may be exposed to precariousness if you provide liquidity for an AMM. It could be small at times, or it could be enormous at other times. If you’re thinking about putting money into liquidity pools on both sides, read our essay first, and then talk about it.

Another consideration is the risk associated with smart contracts. When monies are deposited into a liquidity pool, they become part of the pool. While legally there is no middleman holding your funds, the contract itself can be regarded of as the custodian. If there is a fault or a loophole in a flash loan, for example, your funds could be gone forever.

Also, be aware of projects where developers have the authority to change the pool’s rules. In the smart contract code, a developer may have an admin key or other privileged access. This opens the door for them to do anything nefarious, such as seize control of the pool’s cash. Read our article on DeFi scams to learn how to prevent carpet pull and exit frauds.

REFLECTIONS AT THE END

One of the main technologies in the current DeFi technology stack is liquidity pools. They allow for decentralized trade, lending, and yield production, among other things. These smart contracts currently power practically every aspect of DeFi and will most likely continue to do so in the future.