LIQUIDITY POOL IN DeFi

 A liquidity pool is a collection of digital assets accumulated to enable trading on a decentralized exchange (DEX).

How do liquidity pools make money?

Some liquidity pools have bigger rewards than others. By participating in them, a trader can receive more LP tokens, trading fees, and crypto assets. This optimized method of trading is liquidity mining. This is when a trader makes the maximum possible profit on in-pool fees.

Can you lose coins in a liquidity pool?

When does impermanent loss happen? Impermanent loss happens when the price of a token changes relative to its pair, between the time you deposit it in a liquidity pool and when you withdraw it. Think of it as primarily an unrealized opportunity cost.

Liquidity pools are used to facilitate decentralized trading, lending, and many more functions we’ll explore later.

Liquidity pools are the backbone of many decentralized exchanges (DEX), such as Uniswap. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.

How do liquidity pools work?

Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without the need for an order book. As no direct counterparty is needed to execute trades, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges.

You could think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book. For example, trading on Binance DEX is peer-to-peer since trades happen directly between user wallets.

Trading using an AMM is different. You could think of trading on an AMM as peer-to-contract.

As we’ve mentioned, a liquidity pool is a bunch of funds deposited into a smart contract by liquidity providers. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool.

When you’re buying the latest food coin on Uniswap, there isn’t a seller on the other side in the traditional sense. Instead, your activity is managed by the algorithm that governs what happens in the pool. In addition, pricing is also determined by this algorithm based on the trades that happen in the pool. 

Liquidity pools are one of the foundational technologies behind the current DeFi ecosystem. They are an essential part of automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, blockchain gaming – the list goes on.

In itself, the idea is profoundly simple. A liquidity pool is basically funds thrown together in a big digital pile.

How do liquidity pools work?

Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without the need for an order book. As no direct counterparty is needed to execute trades, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges.

You could think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book. For example, trading on Binance DEX is peer-to-peer since trades happen directly between user wallets.

Trading using an AMM is different. You could think of trading on an AMM as peer-to-contract.

As we’ve mentioned, a liquidity pool is a bunch of funds deposited into a smart contract by liquidity providers. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool.

When you’re buying the latest food coin on Uniswap, there isn’t a seller on the other side in the traditional sense. Instead, your activity is managed by the algorithm that governs what happens in the pool. In addition, pricing is also determined by this algorithm based on the trades that happen in the pool. If you’d like to get a deeper dive into how this works, read our AMM article.

Of course, the liquidity has to come from somewhere, and anyone can be a liquidity provider, so they could be viewed as your counterparty in some sense. But, it’s not the same as in the case of the order book model, as you’re interacting with the contract that governs the pool.

What are liquidity pools used for?

So far, we’ve mostly discussed AMMs, which have been the most popular use of liquidity pools. However, as we’ve said, pooling liquidity is a profoundly simple concept, so it can be used in a number of different ways.

One of these is yield farming or liquidity mining. Liquidity pools are the basis of automated yield-generating platforms like yearn, where users add their funds to pools that are then used to generate yield.

Distributing new tokens in the hands of the right people is a very difficult problem for crypto projects. Liquidity mining has been one of the more successful approaches. Basically, the tokens are distributed algorithmically to users who put their tokens into a liquidity pool. Then, the newly minted tokens are distributed proportionally to each user’s share of the pool.

Bear in mind; these can even be tokens from other liquidity pools called pool tokens. For example, if you’re providing liquidity to Uniswap or lending funds to Compound, you’ll get tokens that represent your share in the pool. You may be able to deposit those tokens into another pool and earn a return. These chains can become quite complicated, as protocols integrate other protocols’ pool tokens into their products, and so on.

We could also think about governance as a use case. In some cases, there’s a very high threshold of token votes needed to be able to put forward a formal governance proposal. If the funds are pooled together instead, participants can rally behind a common cause they deem important for the protocol.

Another emerging DeFi sector is insurance against smart contract risk. Many of its implementations are also powered by liquidity pools.

Another, even more cutting-edge use of liquidity pools is for tranching. It’s a concept borrowed from traditional finance that involves dividing up financial products based on their risks and returns. As you’d expect, these products allow LPs to select customized risk and return profiles.

Minting synthetic assets on the blockchain also relies on liquidity pools. Add some collateral to a liquidity pool, connect it to a trusted oracle, and you’ve got yourself a synthetic token that’s pegged to whatever asset you’d like. Alright, in reality, it’s a more complicated problem than that, but the basic idea is this simple.

What else can we think of? There are probably many more uses for liquidity pools that are yet to be uncovered, and it’s all up to the ingenuity of DeFi developers.

The risks of liquidity pools

If you provide liquidity to an AMM, you’ll need to be aware of a concept called impermanent loss. In short, it’s a loss in dollar value compared to HODLing when you’re providing liquidity to an AMM.

If you’re providing liquidity to an AMM, you’re probably exposed to impermanent loss. Sometimes it can be tiny; sometimes it can be huge.

Another thing to keep in mind is smart contract risks. When you deposit funds into a liquidity pool, they are in the pool. So, while there are technically no middlemen holding your funds, the contract itself can be thought of as the custodian of those funds. If there is a bug or some kind of exploit through a flash loan, for example, your funds could be lost forever.

Also, be wary of projects where the developers have permission to change the rules governing the pool. Sometimes, developers can have an admin key or some other privileged access within the smart contract code. This can enable them to potentially do something malicious, like taking control of the funds in the pool. Read our DeFi scams article to try and avoid rug pulls and exit scams as best you can

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