What are liquidity pools in the DeFi space? How do they work?

 Liquidity pools are one of the foundational technologies of the current DeFi ecosystem. They are an integral and important part of many applications such as automated market makers (AMMs), lending protocols, liquidity mining, synthetic assets, on-chain insurance, blockchain gaming, and more.

The concept itself is fairly simple, essentially pooling funds into a large digital heap. However, what can you do with this digital heap in a license-free environment where anyone can add liquidity to it? Let’s explore how DeFi accomplishes its iteration of the liquidity pooling idea.

Decentralized Finance (DeFi) has spawned a significant amount of on-chain activity, driving decentralized trading platforms to compete with centralized trading platforms for volume share. As of December 2020, the locked-in value of DeFi protocols is approaching $15 billion. The entire ecosystem continues to evolve and grow as new products continue to be introduced.

What are the source drivers of growth? One of the core technologies behind all these products is liquidity pooling.

What is a liquidity pool?

It is a pool of funds locked up in smart contracts that are used to facilitate decentralized trading, lending and borrowing, and many more features discussed later.

Liquidity pools are the backbone of many decentralized trading platforms (DEX), such as Uniswap, where users called “Liquidity Providers (LPs)” add two equivalent tokens to the pool to create a marketplace. In return, transaction fees generated in the pool are paid out to users in proportion to their respective shares of total liquidity.

The AMM makes market making more “accessible” to all by allowing everyone to become a liquidity provider.

Bancor was one of the first protocols to use liquidity pooling, but it wasn’t until Uniswap became popular that the concept gained more attention. Other popular trading platforms in Ether that use liquidity pools include SushiSwap, Curve and Balancer, whose liquidity pools hold ERC-20 tokens.

Liquidity Pooling vs Order Book

In order to understand the differences between liquidity pools, let’s first examine the basic building block of electronic trading — the order book. Simply put, an order book is a collection of currently unfilled orders in a given market.

The system that matches the orders is called the aggregation engine, which, along with the order book, forms the core of a centralized exchange platform (CEX). This model has been effective in facilitating efficient trading and supporting the creation of complex financial markets.

However, DeFi trading involves the execution of trades on the chain with no centralized party holding the funds. The problem arises when an order book is involved. Each interaction with the order book requires a fuel payment, causing the cost of executing trades to rise.

This also leads to market makers (i.e., traders who provide liquidity to pairs) working at a high cost. On top of that, most blockchains have limited throughput and cannot handle up to billions of dollars of transactions per day.

This means that on-chain order book trading is virtually impossible in an Ether-like blockchain. Sidechain or Layer 2 solutions are available to users, but they are currently in the development phase and the network still cannot handle the current throughput.

Even so, a large number of assets in the cryptocurrency space are concentrated in Ether and cannot be traded on other networks unless a cross-chain bridge is used.

How do liquidity pools work?

Automated Market Makers (AMMs) are a game changer. They are among the major innovations that support on-chain trading without the need for an order book. There is no direct counterparty when executing trades, and traders can open or close positions on their own against extremely illiquid token pairs in the order book trading platform.

You can think of order book trading as peer-to-peer trading, where buyers and sellers are connected through an order book. For example, trading on Coin’s decentralized trading platform is peer-to-peer, with transactions taking place directly between users’ wallets.

Transactions using AMM are different and you can think of them as peer-to-contract.

As mentioned earlier, a liquidity pool is a batch of funds deposited into a smart contract by a liquidity provider. When a user executes a trade in an AMM, there is no counterparty in the traditional sense; instead, the liquidity of the liquidity pool is available. The buyer does not need to deal with the seller when buying; there is enough liquidity in the pool to close the deal.

When buying the latest food tokens in Uniswap, there is no counterparty in the traditional sense (i.e. a seller), but instead an algorithm that manages the activity of the pool. In addition, the transaction price is determined by this algorithm based on the transactions in the pool. For a deeper understanding of the mechanism of its operation

Of course, liquidity must have its source, and anyone can be a liquidity provider. In a sense, these people can be seen as your counterparties. However, unlike the order book model, it is the smart contract that manages the pool that you are interacting with here.

What are the uses of liquidity pooling?

So far, we have mainly discussed AMM, which is the most popular application of liquidity pooling. However, as mentioned earlier, pooling liquidity is a very simple concept with many use cases.

One of them is liquidity mining (“yield farming” or “liquidity mining”). Liquidity pools are the basis for platforms that automatically generate revenue, such as yearn. Users add funds to the pool and automatically receive revenue.

Distributing new tokens to the right users is the challenge for cryptocurrency projects. Liquidity mining is one of the more successful approaches. The basic operation is that users add their tokens to the liquidity pool, which distributes exclusive tokens to users based on an algorithm. The newly minted tokens are then distributed to users according to their share in the pool.

Keep in mind that these tokens can even be tokens for other liquidity pools, called pool tokens. For example, if providing liquidity to Uniswap, or lending funds to Compound, you will receive a certain number of tokens representing the share of the pool occupied by your own funds. You can deposit these tokens into another pool to earn income. These chains can become quite complex, as protocols can integrate pool tokens from other protocols into their own offerings, and other such operations.

We can think of governance as a use case. In some cases, the threshold of token voting required to make a formal governance proposal is high. If funds are pooled together, participants can work together to support the same proposal that they endorse.

Another major emerging DeFi segment is insurance against smart contract risk. Many of its implementations are also supported by liquidity pools.

Another, more cutting-edge use case for liquidity pooling is grading. It originated in the traditional finance space, where financial products are graded according to risk and return. As you might expect, these products support liquidity providers in choosing customized risk and return combinations.

Minting synthetic assets in the blockchain also requires the support of a liquidity pool. Adding collateral to the liquidity pool and connecting it to a trusted prophecy machine creates synthetic tokens anchored to any desired asset. This can be relatively complex in practice, but the underlying principle is that simple.

What other use cases can be thought of? More use cases for liquidity pooling are yet to be discovered, and it all depends on the innovative capabilities of DeFi developers.

Risks of Liquidity Pools

When providing liquidity to an AMM, you need to be aware of the concept of “impermanent loss”. Simply put, when a user provides liquidity to an AMM, the asset incurs a loss in dollar value compared to a long-term holding.

If you provide liquidity to an AMM, you may be exposed to an impermanent loss. Such losses can be large or small. Another concern is smart contract risk. When funds are deposited into a liquidity pool, the funds are closely linked to the pool. From a technical point of view, there is no intermediary holding the user’s funds, but the contract itself can be considered the custodian of the funds. If the contract is vulnerable or subject to a flash lending attack, users could lose their funds forever.

Also, one needs to be wary of projects where the developer has the power to change the governance rules of the pool. Developers sometimes have administrative keys or other privileges that give them access to the smart contract code. This provides an opportunity for them to do something nefarious, such as taking control of the pool’s funds.

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summarize

Liquidity pools are one of the core technologies of the current DeFi technology stack. They enable decentralized trading, lending, revenue generation, and much more. These smart contracts can empower almost every aspect of DeFi and are likely to continue in the future.