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What Are Crypto Liquidity Pools, And How Do They Work?

| November 17, 2023

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DeFi needs no introduction because of its relevance in the blockchain sphere. This alternative financial system allows users to leverage their cryptocurrency holdings into tremendous profits. It is further outperforming conventional financial systems in generating value for investors. Little wonder that this aspect of the blockchain is growing and gaining traction with investors, introducing them to many financial use cases — ones that already exist and those that are novel.

An important factor behind the flourishing DeFi ecosystem and its popular applications is the presence of liquidity, allowing users to indulge in all kinds of use cases easily. While centralized systems incentivize institutions or individuals with large amounts of funds to make markets, DeFi allows any user to provide liquidity. In the process of liquidity provision, individual users can expect to make massive profits, the likes of which are yet to be witnessed by traditional instruments. This is possible due to applications known as liquidity pools which, beyond user incentivization, are also responsible for the functioning of the entire DeFi ecosystem.

What Are Liquidity Pools?

Liquidity pools are DeFi’s on-chain answer to liquidity provisioning, keeping the entire process decentralized, autonomous and affordable. Users known as Liquidity Providers (LPs) stake their crypto coins and tokens into smart contracts to keep assets liquid and are remunerated significantly for it.

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Liquidity pools are found on AMM DEXs, lending-borrowing protocols, and yield farms that allow users to exchange, borrow or stake cryptocurrency. Its most popular implementation is often within AMM DEXs which allow users to exchange the tokens they possess for the ones they desire from the pool. Liquidity pools, therefore, eliminate the need for centralized market makers and order books on DeFi exchange platforms.

How Liquidity Pools Work

The removal of vital components found on CEXs makes the functioning of DEXs and their underlying liquidity pools highly interesting. Liquidity pools rely on smart contracts to hold the user-staked crypto, govern the prices of the tokens in the pool and execute trades for the user.

The way liquidity pools work is this — LPs stake cryptocurrency pairs in a 50/50 ratio into these pools. Although liquidity pools on certain protocols contain more than two cryptocurrencies in varying ratios, the most common pools are of the configuration mentioned prior. For example, ETH/USDT pools are quite common on the AMM DEXs operating on the Ethereum blockchain.

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While in the pools, the value of the liquidity is maintained by algorithms based on the supply and demand created through trading activity. These algorithms, called the Automated Market Makers (AMMs), automate processes like liquidity provision and the determination of token prices. Thus, liquidity pools can replace centralized order books and the order books implemented on-chain — which are expensive and cumbersome to operate on crowded networks.

Because of smart contract automation, liquidity pools do not require counterparties to match trades. Order book exchanges function by matching different parties looking to sell and buy assets. Liquidity pool trades are, however, peer-to-contract. Peer-to-contract exchanges involve users acquiring assets from liquidity pools by depositing the other asset in the pair in a process called swapping. Taking into consideration the ETH/USDT pools found across Ethereum DEXs, a user looking to acquire ETH will need to deposit an equivalent value of USDT into the pool.

LPs provide liquidity in such liquidity pools by staking equivalent values of both assets in the pair — a $1000 stake of ETH would warrant a 1000 USDT stablecoins. The AMM algorithm maintains the price of the assets relative to each other. Since the value of USDT remains stable, the value of ETH in the pool will vary based on its abundance or scarcity due to the swaps experienced.

With every cryptocurrency swap, LPs are incentivized by the transaction fees collected from the users and other rewards depending on the liquidity pool. The transaction fees are given to LPs in proportion to their stake in the pool. Upon depositing their funds into the liquidity pool, LPs receive LP tokens signifying their share of contribution to the pool. Apart from these LP tokens enabling LPs to withdraw their contribution from the pool, they can also be used to earn additional rewards in some cases through yield farming. Yield farming contracts allow DeFi participants to stake their LP tokens on a farming contract to earn rewards which are on top of the staking rewards earned from liquidity pools. Yield farming, also known as liquidity mining, incentivizes LP token holders to maintain their stake in the liquidity pool for longer durations.

Despite the potential for making huge returns, users must be wary of the risks associated with liquidity pools. From rug pulls and exit scams to market movements and volatility, cryptocurrencies are high-risk investments, more so while staking for profits in DeFi protocols. One of the common risks associated with liquidity pools is impermanent loss.

Impermanent Loss — A Liquidity Pool Risk

Impermanent loss is a phenomenon associated with liquidity pools where users experience a relative loss in value with their staked assets, which would be worth more if they chose not to stake them at all. Such a loss occurs due to market movements when the value of the staked assets rises or drops. Since the value of assets in liquidity pool pairs are relative to each other, larger market movements of the same assets present arbitrage opportunities.

Thus, arbitrage traders take advantage of the price differences between the same assets present in liquidity pools and other markets like centralized crypto exchanges. The swaps executed by the arbitrage traders leave a disproportionate ratio of tokens in the pool, often diluting the number of tokens whose value rose or increasing the number of tokens whose values dipped. This often leads to a scenario where the total value of the pool at that moment is comparatively lesser than what it would have been if the pool’s users held onto their initial investments. Although the value of the user’s stake in the pool might be higher than their initial stake, they still experience a comparative loss on paper due to the changing ratios of the assets.

This kind of loss is known to be impermanent because it can be offset if the value of the tokens returns to their initial price. It only becomes permanent if the user withdraws their stake at the moment their investments are affected negatively by market fluctuations. Moreover, the trading commissions and rewards earned from the pool can make up for their loss at times. However, it is still important to know the existence of this phenomenon before users dip their toes into liquidity pool staking.

Liquidity Pools Keep DeFi Applications Functioning

Despite the risks associated with liquidity provision in DeFi, users can stand to make tremendous sums from liquidity pools. A comprehensive understanding of how they function will help users invest their funds safer while benefiting from it and benefitting the DeFi ecosystem. Presently, liquidity pools account for a large amount of liquidity flowing through DeFi protocols and will continue to do so. Therefore, liquidity pools play a very important role in the decentralized world, enabling the functioning of all the dApps that need liquidity flowing through them.

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