What is a Liquidity Pool in DeFi? How It Works & Why It Matters

What is a Liquidity Pool?

A liquidity pool is a smart contract that contains a reserve of two or more cryptocurrency tokens in a decentralized exchange (DEX). Liquidity pools encourage investors to earn passive income on cryptocurrencies that would otherwise be idle.

What Liquidity Pools Do

Liquidity pools enable cryptocurrency buyers and sellers to trade tokens on a DEX without the need for a centralized order book or traditional market maker. Instead, all the trading activity is handled by the smart contract that controls the pool.

Automated market maker (AMM) algorithms in the contract determine the price of each token and adjust prices in real time depending on supply and demand. This ensures that the supply of each token in a pool is always in proportion to the other tokens in the pool.

Investors who add their tokens to the pool receive a share of the exchange’s trading fees or some other investment incentive. The value of the incentive earned is proportional to the amount of liquidity the investor provided.

History of Liquidity Pools

In the early phases of DeFi, decentralized exchanges used traditional banking order books to match buyers with sellers. This approach was problematic for a number of reasons:

The order books required a significant amount of computing power to match buyers with sellers, and the process was slow.
High gas fees made it difficult for smaller traders to participate in the market.
Traditional order books are vulnerable to front-running. Users with faster connections could see and execute trades before users with slower connections.

In 2017, Bancor Network’s co-founders figured out a way to counteract these issues by executing trades against the liquidity of a pool of crowdsourced assets. This single change is credited with being responsible for DeFi’s rapid growth.

The Importance of Liquidity Pools

Liquidity pools play an important role in blockchain borrow-lend protocols, yield farming, on-chain insurance, and gaming protocols.

Traditional finance (TradFi) has to pair a buyer with a seller before a transaction can be completed. In contrast, DeFi platforms can automatically execute a trade against the liquidity in the platform’s pool.

This is important because it means DeFi platforms don’t need to match the expected price of a transaction with the executed price. If the executed price of the trade is higher than the expected price, the buyer will simply receive fewer tokens than expected, and the seller will receive more tokens. This is called slippage.

To offset potential losses caused by slippage, the pool charges a small fee for each transaction and splits the fee between liquidity providers in a ratio that’s proportionate to their share of the pool.

Total Value Locked

DeFi liquidity is typically expressed in terms of total value locked (TVL). TVL represents the total value of assets locked in a particular DeFi platform. Typically, this includes the amount of cryptocurrency locked in smart contracts, as well as any other assets that the platform has tokenized.

TVL is an important metric for DeFi protocols because it provides investors with an indication of a platform’s overall liquidity.

Platforms with higher TVL are generally considered to have more potential for growth than platforms with lower TVL.

Risks

Although liquid asset pools provide users with an opportunity to earn a yield on crypto that would otherwise be idle, using them to build passive income also comes with risks.

Once assets have been added to a liquidity pool, they are controlled by a smart contract. If a malicious actor gains access to a smart contract that controls a liquidity pool, they may be able to steal all the funds in the pool.
If smart contract developers grant themselves permission to change the rules governing the pool, there is always the risk the developer will manipulate the contract for their own gain by altering the fee structure, the token ratio, or other key parameters of the pool.
If the ratio of tokens in a liquidity pool becomes uneven due to significant price changes, the liquidity provider (LP) could face permanent as well as impermanent loss of their invested assets.

It’s important for investors to be aware of the risks and take appropriate measures to protect their investments. This includes performing due diligence before investing in a pool.

Best Practices

Before investing in a pool, liquidity providers should thoroughly research the platform in question and the pool itself.

Best practices for ensuring a pool’s rules of liquidity are fair and predictable and that the liquidity providers’ interests are protected include:

Seeking out pools that have a high trading volume and a significant amount of liquidity;
Checking to see whether the liquid asset pool is supported by a strong developer community and has an active user base;
Checking the platform team’s credentials;
Reading the team’s whitepapers and website content;
Finding reviews from other users;
Making sure the liquidity pool has a transparent governance structure and decision-making processes;
Looking for evidence that the pool has undergone independent security audits.

Popular Liquidity Pools

Today, many decentralized platforms use liquid asset pools to trade digital assets in an automated and permissionless way. Popular platforms that center their operations on liquidity pools include:

Uniswap: Uniswap is a decentralized exchange that operates on the Ethereum blockchain and allows users to trade any ERC-20 token. Uniswap has several liquidity pools. Some of their most popular pools support ETH/USDT, ETH/DAI, and ETH/USDC exchanges.

Curve: Curve is a decentralized exchange that specializes in stablecoins and provides low-slippage trading for assets with similar values. Curve has several liquidity pools. Some of their most popular pools support BTC/renBTC/wBTC/sBTC and USDT/USDC/DAI.

Balancer: Balancer is a decentralized exchange that allows users to create customized liquidity pools with up to eight tokens. Some of the popular Balancer pools include ETH/USDC/DAI/WBTC, WBTC/renBTC/sBTC, and LINK/ETH.

SushiSwap: SushiSwap is a decentralized exchange that offers liquidity pools with high-yield farming incentives for liquidity providers. Some of the most popular SushiSwap pools include ETH/USDC, ETH/USDT, and ETH/WBTC.