What are Liquidity pools?
A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens that are locked in a smart contract and used to make trades between assets on a decentralized exchange (DEX). Instead of traditional buyer-seller markets, many decentralized finance (DeFi) platforms use automated market makers (AMMs), which leverage liquidity pools to allow digital assets to be traded in an automated and permissionless manner. One of the core technologies in the present DeFi ecosystem is liquidity pools. They're used in automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, and blockchain gaming, to name a few examples.
How do liquidity pools work?
The most important component of responses to the question "what is a liquidity pool?" is, of course, how they work. Automated market makers (AMM) have shown to be a powerful force in transforming traditional techniques to trading crypto assets. AMMs have emerged as a cutting-edge means of enabling on-chain trading without the use of an order book. You can quickly get in and out of positions on token pairs because there is no direct counter-party for trade execution.
AMMs provide greater trading flexibility for token pairs, which are usually illiquid on order book-based exchanges. Order book exchanges enable peer-to-peer transactions by allowing buyers and sellers to connect through the order book. AMM trading, on the other hand, is distinct in that it concentrates on the interaction between peers and contracts.
Liquidity pools are just a collection of funds deposited into a smart contract by liquidity providers. AMM trades do not have a counter-party, and users must execute the trade with liquidity in mind. If a buyer wants to purchase, they do not need to rely on a seller at this time. On the other hand, sufficient liquidity in the pool may be able to enable the trade's execution.
When you buy the latest food coin on Uniswap, you don't have a seller on the other end. In reality, an algorithm oversees the entire transaction while also overseeing the pool's administration. Furthermore, the algorithm makes use of data from other deals in the pool, allowing it to play a substantial part in pricing.
Another attractive part of DeFi liquidity pools is that anyone can become a liquidity provider. As a result, in such circumstances when there are no identical similarities to the order book model, it is appropriate to consider liquidity providers as the counterparty.
Uses of liquidity pools
- Yield Farming - Liquidity mining or yield farming is the first fascinating use case that is thoroughly outlined. Yearn Finance, for example, uses liquidity pooling as the foundation for its automated yield-generating platform. Users might put their money into pools on these platforms, which would then be used to generate returns.
- Token Distribution - Liquidity mining is also a viable option for distributing fresh tokens to the appropriate individuals in various crypto initiatives. Better efficiency is achieved by the algorithmic distribution of tokens to users who have deposited their tokens in the liquidity pool. Following that, the newly created tokens are allocated according to each user's part of the liquidity pool. It's important to realise, however, that such tokens, also known as pool tokens, could come from various liquidity pools. Users that lend money to Compound or provide liquidity to Uniswap, for example, will receive tokens indicating their stake. You might invest the tokens in a different pool to make a profit.
- Governance - The best liquidity pools could also be useful governance devices. You might find that a higher number of token votes is required to establish a formal proposal for governance. As an alternative, pooling finances could let people unify around a common purpose that is seen as important for protocol. Liquidity pools can also be used to protect against smart contract hazards and for tranching in the DeFi ecosystem. The liquidity pool concept is used in many DeFi implementations to protect against smart contract risks. Liquidity pools can allow for the tranching or division of financial instruments based on their risks and returns. Surprisingly, the products could aid liquidity providers by allowing them to choose from a variety of customizable risk and return profiles.
The risks of liquidity pools
- If you give liquidity to an AMM, you must know the concept of “impermanent loss". When you provide liquidity to an AMM, it's a loss in dollar value compared to HODLing.
You're probably exposed to temporary loss if you provide liquidity to an AMM. It might be small at times and large at others.
- Another item to consider is the risks of smart contracts. When funds are deposited into a liquidity pool, they become part of the pool. While there are no middlemen holding your assets, the contract itself might be considered the custodian of your funds. Your funds could be lost forever if there is a flaw or some form of exploit, such as through a flash loan.
- Also, be aware of projects where the creators have the authority to change the pool's regulations. Within the smart contract code, developers may have an admin key or other privileged access. This could allow them to do anything unethical, such as seize control of the pool's cash.
When attempting to replicate traditional market makers in the early stages of DeFi, DEXs ran into crypto market liquidity issues. Instead of having a seller and buyer match in an order book, liquidity pools helped solve this problem by incentivizing users to provide liquidity. This provided a robust, decentralised solution to DeFi liquidity, which was critical in accelerating the sector's growth. Although liquidity pools were established out of necessity, they have since evolved into a novel technique to deliver decentralised liquidity algorithmically via incentivized, user-funded pools of asset pairs.