The watery consistency of a substance. No, wait! That’s not right. Liquidity in the financial and crypto markets refers to how readily an asset can be bought or sold without drastically affecting the price. Slippage is the variation in an asset’s price that you wanted to sell it for compared to the actual sale price. Liquidity pools are key players in designing a liquid decentralized finance (DeFi) system. In other words, it’s easy to convert assets into cash without losing much value in the process. If an asset is illiquid, that means it takes longer to convert into cash, and you may have to sell at a lower price than you would like.
Now, imagine you’re waiting to order inside a fast-food restaurant. Having lots of cashiers on hand would be like being liquid – it would speed up orders and transactions and make customers happy. On the other hand, not having enough cashiers would be like being illiquid – it would lead to slower orders and transactions, and create unhappy customers.
Traditional finance requires buyers and sellers to create liquidity, whereas, in DeFi, liquidity pools provide this same service. If a DEX does not have access to a liquid pool, it will fail– similar to how a plant needs water to live. Consequently, liquidity pools are vital for the success of decentralized exchanges.
What is a liquidity pool?
A digital “pile” of cryptocurrency locked in a smart contract is called a liquidity pool. This enables faster transactions by creating liquidity. An automated market maker (AMM) is a key element of liquidity pools because it allows trading digital assets automatically, as opposed to the traditional method of buyers and sellers working through a market.
In simpler terms, those who use an AMM platform help supply liquidity pools with tokens. The price of these tokens is then calculated by a mathematical formula that the AMM creates. Liquidity pools are also key for yield farming and blockchain-based online games because they provide encouragement, in the form of rewards or interest payments, for users (called liquidity providers or LPs) of different crypto platforms.
LPs are rewarded with LPTs, equivalent to the amount of liquidity they supplied, after a set period of time. LP tokens can then be used in different ways on a DeFi network. SushiSwap (SUSHI) and Uniswap are popular DeFi exchanges that use liquidity pools containing ERC-20 tokens on the Ethereum network. Meanwhile, PancakeSwap uses BEP-20 tokens on the BNB Chain.
The main purpose of a liquidity pool
In a trade, the price that is executed can sometimes be different than the expected price- this occurs in both traditional and cryptocurrency markets. The liquidity pool intends to fix this problem by giving users rewards, and in return, they provide liquidity for a certain percentage of trading fees.
Amano makes it possible to trade quickly and easily on DEX markets without having to match the expected price with the executed one. Liquidity pool programs, like Uniswap, power AMMs so that buyers and sellers of crypto can find each other efficiently.
What rewards do liquidity providers and depositors receive? Debt investors can earn a high return on their investment by lending out their money to people or businesses in need. This is a relatively low-risk way to invest, as the borrower usually pays back the loan plus interest over time. The size of the return depends on the interest rate set by the lender, which is often higher than what you could earn from a savings account.
How does it work?
As mentioned above, staking digital assets in a liquidity pool is typically rewarded with cryptos or a fraction of trading fees from the exchanges where the pool is located. The design of an operational crypto liquidity pool is important to incentive crypto liquidity providers to stake their assets in the pool. For that reason, most liquidity providers earn trading fees and rewards in cryptocurrency form from the exchanges they supply tokens for.
When a user provides liquidity to a pool, they are often rewarded with liquidity provider (LP) tokens. LP tokens can be valuable assets in their own right and can serve various purposes throughout the DeFi ecosystem.
A crypto liquidity provider receives LP tokens based on the amount of liquidity they provided to the pool. When a trade is facilitated by the pool, a fee is distributed among all of the token holders. The only way for a liquidity provider to get back their contributions and any fees from their portion is if they destroy their LP tokens.
To keep market values fair for the tokens they hold, liquidity pools use AMM algorithms. These algorithms compare the prices of different tokens to one another and maintain price ratios among them. For example, Uniswap uses a constant product formula while many other DEX platforms utilize a similar model. This algorithm provides market liquidity for a pool of tokens by consistently managing the cost and quantity ratio as demand increases.
Platforms that utilize liquidity pools for trading digital assets in a permissionless and automated way are gaining popularity. In fact, there are entire platforms dedicated to providing liquidity pool services.
- Uniswap – This platform enables users to trade ETH for any other ERC-20 token without needing a centralized service. It is an open-source exchange, and anyone can start an exchange pair on the network at no cost.
- Curve – Is designed for stablecoins and it’s based on the Ethereum network. Stablecoins are not volatile, it gives reduced slippage.
- Balancer – This is a platform that provides several pooling options like shared and private liquidity pools, that offer benefits for its providers.
Pros and cons
The better side of a liquidity pool is that real-time market prices are used to perform transactions, allowing people to provide liquidity and receive rewards, interest, or an annual percentage yield on their crypto. Publicly viewable smart contracts keep security audit information transparent.
On the other hand, a limited group manages the central pool of funds, which is opposed to decentralization. Liquidity providers are at risk of losing money because of inadequate security measures against hacking attempts.
There is also a chance of fraud, such as investors being scammed by those who created the investment opportunity in the first place (‘rug pulls’) or ‘exit scams’, where people leave suddenly instead of continuing to invest. Another issue related to liquidity pools is impermanent loss, which occurs when market changes result in unrealized losses on assets that were locked up rather than kept in one’s own wallet.
Why are liquidity pools important?
Traders in both traditional and crypto markets are all too familiar with the potential downside of entering a low-liquidity market. Whether it’s a small-cap cryptocurrency or penny stock, slippage is always a concern when trying to enter or exit any trade. Slippage occurs when the actual price differs from the expected price of the trade.
Slippage is more often than not a product of increased market volatility, and can also take place when a sizable order is carried out but there’s inadequate volume present at the selected price to uphold the bid-ask spread.
The actual value per trade that buyers and sellers are willing to transact at in an order book defines the bid-ask spread within that same order book. When large orders exist but prices aren’t as favorable, due to either low trading volumes or high market volatility depressing liquidity, this creates conditions where slippage may materialize.
The mid-market price falls in the middle of what both buyers and sellers are willing to accept for an asset. Low liquidity, though, can cause more slippage, which is the difference between the market order’s original price compared to its execution price. The bid-ask spread meaning how much buyers differ from sellers on what they’re willing to pay or accept at any given time can also contribute to this problem.
Liquidity pools incentivize users to trade their tokens and assets, providing liquidity in the form of smart contracts. This solves the problem of markets that would otherwise be illiquid and requires no buyer or seller matching- making it simpler for everyone involved.
The unexpected value of liquidity pools
DEXs (decentralized exchanges) was struggling in the earlier days of DeFi (decentralized finance). The main issue was that there wasn’t enough liquidity in the crypto markets. To solve this problem, developers created liquidity pools. These new structures incentivize users to provide liquidity instead of just having a buyer and seller match up in an order book.
Decentralized finance (DeFi) aims to disintermediate financial products and services using decentralized technologies built on the Ethereum blockchain. Incentivized, user-funded liquidity pools of asset pairs Bring a fresh new way to provide decentralized liquidity algorithmically through incentivized, user-funded pools of asset pairs.