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Liquidity pools are large funds of money used to facilitate the trading of tokens on decentralised exchanges (DEX). These crowd sourced pools of cryptocurrency provide much-needed liquidity so digital assets can be traded for each other using automated market makers. Together, liquidity pools and their providers are enabling the flourishing of decentralised finance.
Here, we’ll take a closer look at liquidity pools and ask exactly what their role in DeFi is.
What is a liquidity pool?
A liquidity pool is a vault into which users deposit different crypto-assets to make DEX markets more liquid. By depositing into a liquidity pool, users create “trading pairs” which form a market. These trading pairs enable users to trade different cryptocurrencies for each other.
The vault itself is ultimately a smart contract, meaning the whole process is handled automatically by code. This makes liquidity pools permission less. This is an important concept in decentralised finance as it means there is no need for trust between parties as the process is handled automatically and securely.
How do liquidity pools work?
Traditional, centralised exchanges rely on order books and market makers to boost liquidity, facilitating trades. This model is inappropriate for DeFi as the trades are happening rapidly on-chain and would incur significant fees.
Instead, automated market makers (AMM) are used to facilitate on-chain trading and govern prices without relying on order books. Using complex algorithms and smart contracts, AMMs are constantly rebalancing prices according to supply and demand, allowing traders to obtain positions using illiquid pairs that would otherwise be difficult to execute.
This is because when executing a trade using an AMM you are trading against the liquidity in the pool, making virtually any token pair possible (e.g., USDC-ETH). This means, as a buyer, you don’t need to be matched up with a seller but, instead, only for there to be adequate liquidity in the pool itself.
Yield farming
In order to encourage users to deposit and “lock-in” their cryptocurrency to liquidity pools, protocols offer incentives, usually in the form of liquidity pool tokens. These tokens represent the user’s stake in the pool and have a value of their own.
This is known as yield farming or liquidity mining. Users’ funds are typically locked up for a set period of time, with the reward calculated as the annual percentage yield (APY) of their contribution.
On Ethereum, most deposits are made using an ERC-20 token, with the yield rewards issued the same. Rewards for pledging assets into liquidity pools are funded by the protocol’s fees or are newly minted. Other blockchains have their own token standards but follow a similar model.
The future of liquidity pools
Liquidity pools are proving instrumental in bridging the gap between blockchains. Cross-chain bridges are an emerging technology that allows different blockchains to interoperate securely. These bridges facilitate the interaction between disparate networks’ token standards and smart contract code, allowing trading between them.
For DeFi, this makes the need for automated market makers (and liquidity pools especially) even greater. Liquidity pools will allow the trading of pairs no matter how illiquid the tokens are.
As well as the growing DeFi insurance sector, liquidity pools are also being put forward as a way to boost voting power with governance tokens. With like-minded people pooling their governance tokens, users can effect change in different protocols if enough support is provided.
Liquidity pool risks
While rare, there are some risks to using liquidity pools.
- Smart contract bugs: AMMs rely on smart contracts to function. This poses a potential security risk in terms of human error, bugs, or exploits.
- “Impermanent loss”: this occurs when the price of your locked-in assets changes in relation to when you added them to the pool.
Verdict
For the DeFi ecosystem as a whole, liquidity pools will continue to be essential to the sector’s growth. Allowing an ever-growing number of tokens to be exchanged, liquidity pools are the perfect solution to the illiquidity problem DeFi faces. If you are looking to learn more about liquidity pools and other crypto strategies at the lowest fees in Australia, check out Swiftx.com.
Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not reflect the views of Bitcoin Insider. Every investment and trading move involves risk - this is especially true for cryptocurrencies given their volatility. We strongly advise our readers to conduct their own research when making a decision.