Liquidity Pools

Let’s dip our feet in the topic of liquidity pools

For some readers, this might be the first you’ve ever heard of liquidity pools, but stay tuned, because they’re the backbone of decentralized finance (DeFi).

In this article, we are going to explain, in simplified terms:

What liquidity pools are
Why we need them
How they work
And what risks they pose

A liquidity pool is a collection of tokens locked into a smart contract. They help traders and decentralized exchanges by providing liquidity. In providing this liquidity, they help DEXs to avoid major price changes when large trades go through.

Without the help of a liquidity pool, an exchange is vulnerable to arbitrage or low liquidity, which can both be exploited by very savvy traders, or can result in a lack of trades.

The most well-known projects with liquidity pools are:

Do we need liquidity pools?

In the world of DeFi, the answer is yes. When you analyse a standard crypto exchange like Bitfinex, Binance, or Coinbase, you will note that their trading operation works through an order book. The stock market also works in the same way.

Using an order book, you attempt to buy a currency or asset at the lowest price, or sell it at a high price. This is how you create value for your trades. A trade will take place when the price reaches the value in the order book, however, this doesn’t always happen. Sometimes, the sell orders are too high and the buy bids are too low, with few people willing to meet in the middle. Experienced traders are constantly adjusting their orders so that they can maximise profits.

This issue is solved by market makers, who make trades happen by always being willing to buy or sell, which in turn provides liquidity to a market. The result is that traders won’t have to wait so long for their trades to go through. In DeFi, this same process doesn’t really work. It is too slow, too expensive, and isn’t useful to decentralized traders. A market could very quickly become illiquid.

Thankfully, liquidity pools provide a solid alternative.

How Do Liquidity Pools Work?

Ok, so now that we understand why we need liquidity pools in decentralized finance, let’s see how they actually work.

A single liquidity pool holds 2 tokens, with each new pool creating a market pairing. When a new pool is formed, the liquidity provider states the initial price of the assets in the pool, and they should then supply both tokens to the pool in equal value.

When the initially stated price of the tokens in the pool is different from the actual market price, traders can take advantage of an arbitrage opportunity which would negatively affect the liquidity provider. To counteract that effect and to incentivise liquidity providers, they receive special LP tokens proportionate to their liquidity supply. Each time a trade goes through using their liquidity pool, the token holders receive a small bonus (a share of a 0.3% fee) that reflects how much of the liquidity they provide.

Like with the stock exchange or forex, each trade results in a price adjustment, which in the DeFi world is performed by mechanisms called Automated Match Makers. Different exchanges and liquidity pools will manage this algorithmic price adjustment differently, which is why all exchanges do not offer the exact same market prices.

What all of this means is that decentralized exchanges can use liquidity pools to enable both large and regular trades, as the liquidity pools can grow to be very large. An algorithm manages the quantities of the two supplied tokens and the respective prices to maintain balance. The result is that decentralized exchanges can offer an increased level of liquidity.

For example:

There is a liquidity pool of X and Y. You purchase some Y with some X, reducing the supply of Y for others, but increasing the supply of X. This results in a price increase of Y and a decrease of X. The price adjustment that then takes place depends on the size of the trade in relation to the size of the liquidity pool. A bigger pool will reflect smaller price changes.

Are there some inherent risks with liquidity pools?

DeFi is fantastic, but not flawless. Like with any DeFi tool, beware of smart contract bugs, and systemic issues. With regards to liquidity pools, be cautious of impermanent loss and liquidity pool hacks. Where there is crypto, there are often hackers.