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What Is a Liquidity Pool? The Core Technology Behind DeFi

Decentralized finance has shaken up the traditional financial system by moving multiple services onto blockchains, decentralizing them, and bypassing the middlemen.

Liquidity pools however, shaped the whole DeFi ecosystem by enabling the fundamental technology that makes decentralized trading possible, and working as a catalyst for the growth of DeFi.

Let’s learn more about them.

What is Liquidity?

Imagine, you own the world’s best ever spaceship, but nobody wants to buy it from you. There are several people who probably would like to, but only for half of its price.

Your spaceship is severely illiquid.

The same might happen with cryptocurrencies. You may have the most promising one, but if the market is vague, you can’t sell it instantly, or without huge variance between the buying and selling prices. You need a liquid market to do that.

Liquidity, for the market, is like blood for living beings, it means life and activity. Liquidity determines and greatly affects asset prices, lowers the risk of price gaps, and correspondingly reduces price volatility as well as the cost of investing.

How is Liquidity Created?

Liquidity does not come naturally, it has to be created.

Centralized crypto exchanges (like Coinbase or Binance) have lists of buy and sell orders, called order books. These orders come from market participants that agree to buy or sell assets at a settled price.

As soon as the market meets their conditions, these orders are fulfilled. Until then, open orders remain pending, creating liquidity.

For decentralized crypto exchanges (DEXes), liquidity is created differently. There are no orders books in this system, instead, assets are traded via liquidity pools that are operated by a decentralized technology called Automated Market Makers (AMMs).

What Is a Liquidity Pool?

A liquidity pool is the shared pool of tokens locked in a DEX smart contract in order to create liquidity for market participants. Basically, it’s a decentralized market and the critical working model of decentralized exchanges.

Previously, DEXes tended to suffer from a lack of trading activity. Their volumes were low, and liquidity inefficient, making fluent decentralized trading impossible. The traditional order book model simply didn’t work on decentralized exchanges.

AMM technology and liquidity pools changed the situation. Decentralized AMMs brought the ability to create liquidity via liquidity pools. To achieve this, they enabled incentives and rewards for liquidity providers, thus prompting people who bring their tokens into the pool.

The automated market-making solution revolutionized the way DEXes work. It fixed the problem of inefficient liquidity and acted as a turning point for the growth of the entire DeFi ecosystem.

How Does a Liquidity Pool Work?

To fully understand how liquidity pools function, it’s important to know how they get the liquidity first, and what determines asset prices.

Liquidity Providing

The AMM protocol creates the liquidity pool, or market, for a certain trading pair of digital assets. The initial liquidity provider sets the initial price, and equal supply for both assets.

The liquidity pool starts filling with assets that market participants deposit into smart contracts. Such users are called ‘liquidity providers (LPs),’ and this can be anyone who brings tokens to the pool.

Liquidity providers do so by bringing tokens into the pool through staking. The method allows the locking of assets into a certain protocol for a specified period of time. The assets then circulate in the liquidity pool, enabling decentralized trading. Meanwhile, the original owners earn passive income for their contributions.

For bringing supply to the pool, liquidity providers receive special tokens. These tokens are called ‘LP tokens,’ and are distributed proportionally to the amount of liquidity each provider brings to the pool. Whenever a pool executes a transaction, a certain transaction fee is proportionally distributed among all LP token holders.

Each time a liquidity provider withdraws assets from the pool, an LP token is burnt.

Price Calculation

Due to the AMM mechanism, trading in liquidity pools is automated and takes place between the traders and the pool.

Coin and token prices are determined by the algorithm, which is set to keep a constant balance of both assets in the liquidity pool. In other words, the price depends on the ratio of the pool’s assets, rather than on external markets.

Whenever traders buy one of them, its resources in the pool decrease, and the price automatically jumps up. Conversely, whenever traders sell, the asset supply increases, and the prices drop.

The proportion of the trade size and the pool size determine how much asset prices can be affected. Larger trades might cause volatile price swings in smaller liquidity pools, while bigger pools can accommodate large trades without incurring a serious impact on prices.

Benefits of the Liquidity Pool

  • Liquidity pools enable decentralized trading and reduce dependence on traditional market makers, which might not always be neutral market participants.
  • Liquidity providing is more profitable than holding, as assets generate passive income, thereby giving participants guaranteed returns that they can then reinvest.
  • Rewards for providing liquidity are better than nothing when the market goes sideways. They guarantee regular income whenever the markets slow down.

On The Flipside

  • As with any other DeFi protocol, liquidity pools are vulnerable to cybersecurity risks like smart contract bugs, security issues, or protocol hacks.
  • Rug pull fraud is another common risk in DeFi. This is an exit scam method in which fraudsters first launch tokens that seem to be credible, list them on decentralized exchanges (DEXes) and then suddenly vanish with all their investors’ funds.
  • Cryptocurrencies are especially volatile, their prices may change drastically within a short time frame. When deposited with a certain price, they may suddenly change in value and generate impermanent losses.
  • Removing liquidity from the pools might come with costly fees. Bear in mind that multiple liquidity pools operate on the Ethereum blockchain, on which gas fees reach severe highs as markets become crowded.

Why You Should Care?

Liquidity always affects asset prices and is thus a factor of key importance for any type of the market. For the decentralized space, liquidity pools are the fundamental technology that enable decentralized trading, and massively contribute to the growth of the entire DeFi ecosystem.

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    This article is for information purposes only and should not be considered trading or investment advice. Nothing herein shall be construed to be financial legal or tax advice. Trading Forex, cryptocurrencies, and CFDs poses a considerable risk of loss

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    Author

    Simona is a fintech journalist and content editor at DailyCoin Academy, which focuses on educating new crypto investors. She entered the crypto space in early 2018, got burned, but discovered a passion for trading, and now it’s her hobby. Simona covers crypto and blockchain-related topics and takes a deeper look at what lies behind the latest industry trends.