Liquidity Pools in DeFi and How They Operate
Introduction
Decentralized Finance (DeFi) has created an explosion of on-chain activity. DEX volumes can meaningfully compete with the volume on centralized exchanges. As of December 2020, there are almost 15 billion dollars of value locked in DeFi protocols. The ecosystem is rapidly expanding with new types of products.
But what makes all this expansion possible? One of the core technologies behind all these products is the liquidity pool.
What Is a Crypto Liquidity Pool?
A liquidity pool is a pool of crypto tokens secured under a smart contract. These tokens provide decentralized exchanges with the essential liquidity they require. The term “liquidity” refers to the ease with which one can swap a crypto token for another. Such ease is essential to the DeFi ecosystem because of the numerous financial activities carried out in it.
Although the decentralized trading sector contains a great number of liquidity pools, only a select few of them have established themselves as the investors’ first choice. They include Uniswap, Balancer, Bancor, Curve Finance, PancakeSwap, and SushiSwap.
How a Liquidity Pool Works Versus an Order Book
A liquidity pool is like a pot containing crypto coins locked up in a smart contract that allows people to trade easily. The importance of liquidity pools is better understood when we compare them with traditional order books.
The order book is a digital list of crypto buy and sell orders arranged by price levels and updated continuously in real-time. In simple terms, buyers and sellers submit orders for the number of tokens they want to trade and at what price.
The method requires that someone else be willing to meet the order. Otherwise, traders would transact at an unfavorable price or wait for a long time to see someone who meets their desired price.
A liquidity pool is, by default, a 50:50 ratio of 2 coins. Let’s say 50% bitcoin (BTC) and 50% ether (ETH). When you buy BTC with ETH, the pools will start to lose BTC and get more ETH. The algorithm increases the price of bitcoin and lowers the price of ether to keep the ratio regulated. The process is a self-regulated automated reaction to the market’s needs.
Advantages of Liquidity Pools
Below are three benefits that liquidity pools have over traditional market-making systems.
1. There Is Liquidity at All Price Levels
You don’t have to connect to other traders to trade because there is always liquidity as long as client assets remain in the pool.
You won’t need to worry about finding a partner that would like to trade at the same price as you. Instead, the algorithm adjusts the value of crypto based on the platform’s exchange rate.
2. Better Price Balance
With liquidity pools, no seller can demand high market prices. Likewise, buyers cannot devalue the market price below the average price. As a result, the transactions are smoother, and the market is more balanced.
As soon as a liquidity provider deposits money into the pool, smart contracts take complete control of setting the price.
3. Anyone Can Provide and Benefit From It
The provision of liquidity is not limited to market makers, and anyone can provide liquidity. Listing fees, KYC requirements, and other barriers associated with centralized exchanges are not required for liquidity pools. To provide liquidity to the pool, you will only need to make a deposit that is equal in value to the assets.
Liquidity providers are usually rewarded with fees, which can be a form of passive income.
Risks of Liquidity Pools
There are also some drawbacks to liquidity pools. Three of these issues are explained below.
1. Impermanent Loss
The value of a crypto token may change in comparison to another due to demand and supply activities, leading to an impermanent loss of value. This issue occurs when the ratio of two assets that are held ends up being unequal due to a sudden price increase in one of the assets.
2. Smart Contract Vulnerabilities
Smart contracts manage the assets added to a pool; there is no central authority or custodian for these assets. Therefore, you could permanently lose the coins if a vulnerability is discovered.
Performing smart contract audits is a good way to ensure that smart contracts are safe from security breaches. However, the process necessitates a close look at the source code to look for potential flaws.
3. Developers Hijacking Pools
There is an opportunity for fraud in a highly centralized liquidity pool. For example, one of the developers in the pool can hijack the pool’s resources. As a result, you must select your liquidity pool carefully and conduct adequate due diligence before depositing your crypto.
Bottomline
Liquidity pools are one of the core technologies behind the current DeFi technology stack. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power almost every part of DeFi and will most likely continue to do so.
