What Are Liquidity Pools in DeFi?

Introduction

The rise of decentralized finance (DeFi) has led to a surge in on-chain activity, resulting in intense competition between decentralized exchanges (DEXs) and centralized exchanges (CEXs) in terms of trading volume. As new products continue to emerge, the entire ecosystem is consistently evolving and expanding.

So, what is the core driving force behind this development? One of the key technologies behind all these products is the liquidity pool.

What is a Liquidity Pool?

A liquidity pool is a collection of funds locked in a smart contract, designed to facilitate decentralized trading, lending, and other functionalities.

Liquidity pools form the foundation of many decentralized exchanges, such as Uniswap. Users, referred to as "liquidity providers (LPs)," contribute two equivalent tokens to the pool to create a market. In return, transaction fees generated by the pool are distributed based on their proportion of the total liquidity.

Anyone can become a liquidity provider, and automated market makers (AMMs) make this process more accessible.

Bancor was one of the earliest protocols to utilize liquidity pools, but the concept gained more attention with the popularity of Uniswap. In the Ethereum ecosystem, other popular trading platforms using liquidity pools include SushiSwap, Curve, and Balancer, which support ERC-20 tokens. On the Binance Smart Chain (BSC), similar platforms such as PancakeSwap, BakerySwap, and BurgerSwap support BEP-20 tokens.

Liquidity Pools vs. Order Books

To understand the characteristics of liquidity pools, we must first examine the basic structure of electronic trading: the order book. Simply put, an order book is a collection of current unfilled orders in a specific market.

The system that matches orders is called a matching engine, which, along with the order book, forms the core of centralized exchanges (CEXs). This model excels in facilitating efficient trading and supporting the creation of complex financial markets.

However, DeFi trading involves on-chain execution, lacking a centralized party to hold the funds. This creates challenges when it comes to order books. Every interaction with the order book requires a gas fee, leading to increased transaction execution costs.

This results in market makers—traders providing liquidity for trading pairs—bearing high operational costs. More importantly, most blockchains have limited throughput and cannot handle billions of dollars in transactions daily.

As a result, on-chain order book trading is nearly impractical on blockchains like Ethereum. Users may opt for sidechains or Layer 2 solutions, but these are still under development, and the networks are not yet capable of handling the current transaction throughput.

It is worth noting that while there are some decentralized trading platforms with functioning on-chain order books, they are relatively few. For example, Binance DEX is built on Binance Chain and designed for fast, low-cost trading. Another example is the Serum project, which operates on the Solana blockchain.

Despite this, many assets in the cryptocurrency space remain concentrated on Ethereum, making it challenging to trade on other networks without cross-chain bridges.

How Do Liquidity Pools Work?

Automated Market Makers (AMMs) have revolutionized the way trading occurs. This significant innovation allows for on-chain trading without relying on order books. When executing a trade, traders do not need to interact directly with a counterparty; instead, they can open or close positions in token pairs with very low liquidity.

Order book trading can be thought of as a peer-to-peer model, where buyers and sellers connect through the order book. For instance, on a decentralized exchange like Binance DEX, trades occur directly between users' wallets in a peer-to-peer manner.

In contrast, trading using AMMs can be seen as a point-to-contract model. As previously mentioned, liquidity pools consist of funds provided by liquidity providers locked in a smart contract. When users execute trades in an AMM, there isn’t a traditional counterparty; rather, the liquidity is provided by the liquidity pool. Buyers do not transact directly with sellers; as long as there is sufficient liquidity in the pool, the transaction can be completed.

For example, when you purchase the latest food-related token on Uniswap, there is no traditional seller involved; instead, there is an algorithm managing the pool's activities. The transaction price is determined by this algorithm based on the trading conditions within the pool. For a deeper understanding of how this mechanism works, you can refer to our related articles on AMMs.

Of course, the liquidity in a liquidity pool comes from users, meaning anyone can become a liquidity provider. In a sense, these users can be viewed as your counterparties. However, unlike the order book model, you interact with the smart contract that manages the pool.

What Are the Uses of Liquidity Pools?

So far, we have primarily discussed AMMs, which are the most popular application of liquidity pools. However, pooling liquidity is a simple concept that has numerous applications.

One significant use case is liquidity mining (also known as yield farming). Liquidity pools serve as a foundation for platforms that automatically generate yields (like Yearn). Users deposit funds into the pool and automatically earn returns.

Distributing new tokens to the right users is a major challenge for cryptocurrency projects, and liquidity mining is one effective way to address this issue. The basic operation involves users depositing tokens into a liquidity pool, after which the pool allocates exclusive tokens to users based on an algorithm. Newly minted tokens are distributed according to the user's share in the pool.

It is important to note that these tokens can be the tokens of other liquidity pools, referred to as pool tokens. For example, if you provide liquidity to Uniswap or lend funds to Compound, you will receive a certain number of tokens representing your share in the pool. You can also deposit these tokens into another pool to earn yields. Over time, this chain structure can become quite complex, as different protocols can integrate the pool tokens of other protocols into their own products.

Another use case is governance. In some instances, the token voting threshold required to propose formal governance proposals is quite high. By pooling funds, participants can collectively support the proposals they endorse.

Additionally, liquidity pools have widespread applications in the insurance sector for mitigating smart contract risks.

A cutting-edge use case for liquidity pools is tranching, a concept borrowed from traditional finance that classifies financial products by risk and return. As you might expect, these products allow liquidity providers to choose customized risk-return combinations.

Minting synthetic assets on the blockchain also requires the support of liquidity pools. Users can deposit collateral into a liquidity pool and connect to trusted oracles, thereby creating synthetic tokens pegged to any asset. While the actual implementation can be relatively complex, the underlying principle is quite straightforward.

What other use cases exist? The potential applications of liquidity pools are still being developed, and future innovations will depend on the creativity of DeFi developers.

Risks of Liquidity Pools

When providing liquidity for Automated Market Makers (AMMs), it is crucial to pay special attention to the concept of "impermanent loss." Simply put, providing liquidity to an AMM may result in losses measured in USD compared to holding the assets long-term.

Before participating in a two-sided liquidity pool, be sure to read the relevant materials carefully to understand the impermanent loss you may face. The extent of this loss can vary and may sometimes be quite significant.

Additionally, smart contract risk is an important factor to consider. Once you commit funds to a liquidity pool, those funds become tightly linked to the pool. Technically, while no intermediary directly holds your funds, the smart contract itself acts as the custodian. If there are vulnerabilities in the contract or it falls victim to a flash loan attack, users may incur irreversible losses.

Furthermore, be cautious of projects where developers have the authority to change the governance rules of the liquidity pool. Some developers may possess management keys or other privileges that give them access to the smart contract code, creating opportunities for misconduct, such as controlling the pool's funds. It is advisable to read our articles on DeFi scams to avoid "rug pull" schemes.

Conclusion

Liquidity pools are a core component of the current DeFi tech stack. They not only enable decentralized trading and lending but also support various functions like yield generation. These smart contracts power nearly every aspect of DeFi and are expected to continue playing a significant role in the future.

Risk Warning

While the cryptocurrency market offers significant growth potential and innovation opportunities, it also carries a high level of market risk and price volatility. The value of crypto assets can fluctuate dramatically in a short period, potentially leading to substantial financial losses for investors. Additionally, the cryptocurrency market faces multiple risk factors, including technical risks, legal and regulatory uncertainties, cybersecurity threats, and market manipulation. We strongly advise users to conduct thorough research and due diligence before making any investment decisions and to consult professional financial advisors. All investment decisions are made at the user’s own risk. Thank you for your trust and support of Venkate!

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