DeFi is an abbreviation for decentralized finance. These would be the decentralized applications that blockchain developers build: creative algorithms, financial markets, exchange protocols, digital wallets, and other services that allow individuals to interact with one another without using centralized institutions like banks.
DeFi is not just a new way of doing business because it’s possible to create these tools without a central governing body.
The majority of today’s decentralized finance (DeFi) protocols rely heavily on liquidity pools as their primary source of funding.
They make it possible for many of the most popular decentralized finance applications (dApps) to work, and they provide crypto investors with a means of earning yield on their digital assets. It is estimated that there is more than $30 billion worth of value locked up in liquidity pools as of the time this article was written.
However, what exactly are liquidity pools, and why do they play such a significant part in the world of decentralized finance?
This page explains what liquidity pools are, how they function, and why they are such an important part of the DeFi ecosystem.
What are Liquidity Pools?
To understand how liquidity pools work, it’s necessary to first understand what a liquidity pool is.
A liquidity pool is usually comprised of a diverse collection of different assets, including cryptocurrencies, cash, and other types of digital assets. In the world of DeFi, the most popular form of asset that you’ll find in a liquidity pool would be Ethereum-based tokens.
The capacity of an asset to be sold or traded rapidly and without a significant impact on its price is referred to as its liquidity. To put it another way, liquidity can be understood as a measurement of how easily an asset can be changed into cash.
A decentralized exchange cannot function without a liquidity pool, which is a collection of digital assets that have been gathered over time (DEX). A decentralized exchange (DEX) is an exchange that does not depend on a third party to keep the funds belonging to its users. Instead, DEX users conduct business with one another in a straightforward manner.
However, decentralized exchanges (DEXs) have a higher demand for liquidity than centralized exchanges do. This is since DEXs do not have the same mechanisms in place to connect buyers and sellers. They make use of Automated Market Makers (AMMs), which are mathematical functions that determine prices according to supply and demand in the market.
Because decentralized exchanges cannot function properly without the liquidity that is provided by liquidity pools, these pools are a vital component of decentralized exchanges.
They are generated when users lock their cryptocurrencies into smart contracts, which then enable them to be utilized by others. This is somewhat analogous to how businesses change money into debt or equity by borrowing it.
One way to think of liquidity pools is as crowdfunded storage areas for cryptocurrencies that are open to anyone who wants to use them. Those who fund this reservoir get a percentage of the transaction fees generated by each interaction made by users. This is their reward for supplying liquidity to the system.
Without sufficient liquidity, Automated Market Makers (AMMs) would be unable to successfully match buyers and sellers of assets on a Decentralized Exchange (DEX), causing the entire system to come to a grinding halt. However, liquidity pools imply that AMMs are unable to provide the liquidity necessary to match orders to one another.
Over time, fundraising for liquidity pools has increased rapidly. Unlike ICOs, which tend to receive most of their funding in the early days of their existence (as coin offerings are only available for a defined period), raising funds for a liquidity pool occurs gradually over time.
In addition, some research has shown that a significant amount of funds that have been raised for this purpose have not been utilized within the industry.
This potentially idle capital is known as phantom liquidity, and it has posed a problem for the DeFi industry. Phantom liquidity can prevent a system from functioning properly, as it has the potential to cause over-collateralization of liquidity pools.
Over-collateralization, which is defined as more capital being supplied than needed by a ratio of 2 to 1 or more, happens when too much money is collected to provide sufficient liquidity.
How do liquidity pools work?
How do these entities work, and why do they fall under the DeFi umbrella? As previously mentioned, liquidity pools are crowdfunded storage areas for digital assets that can be utilized by many users simultaneously.
Users deposit their crypto holdings into a pool, and in exchange, they receive a proportional payment of transaction fees. Arguably the most notable example of this is MakerDAO.
MakerDAO is a platform that allows users to generate Dai, which is pegged to the US dollar on a 1-to-1 basis. This game has been significantly altered as a result of automated market makers, or AMMs. They represent a significant technological advancement that makes on-chain trading possible without the requirement of an order book.
Traders can enter and exit positions on token pairs that, if they were conducted on order book exchanges, would likely be considered to have a very low level of liquidity because direct counterparties are not required to complete trades.
One way to think of an order book exchange is as a form of peer-to-peer trading, in which buyers and sellers are brought together through the use of the order book. For instance, trading on Binance DEX is considered peer-to-peer because deals are executed directly between the wallets of different users.
Trading with an automated market maker (AMM) is different. One way to think of trading on an AMM is as participating in a peer-to-peer contract.
A liquidity pool is, as was discussed earlier, a collection of monies that are deposited into a smart contract by several liquidity providers. You do not have a counterparty in the usual sense while you are carrying out a deal through the use of an AMM.
You are instead executing the trade against the liquidity that is contained in the liquidity pool. It is not necessary for there to be a seller present at that precise moment for there to be adequate liquidity in the pool for the buyer to make a purchase.
On Uniswap, when you are purchasing the most recent food coin, there is not a vendor on the other side in the classic sense. Instead, the algorithm that controls the activities that take place in the pool will regulate your activity for you.
This algorithm uses the trades that take place within the pool to determine not just the pricing but also the winners and losers. Read our post on AMM if you would want to have a more in-depth understanding of how this operates.
Naturally, the liquidity must originate from some source, and since everyone has the potential to act as a liquidity provider, that person can in some ways be seen to be your counterparty. However, it is not the same as the case with the order book model because you are engaging with the contract that rules the pool. This makes the situation much different.
Although it was not an official requirement of the original ERC-20 token standard, most tokens issued on the Ethereum network will have a set amount of tokens that can be spent.
The Uniswap team regards it as their duty to ensure that all holders of these tokens can utilize those tokens in a completely fair way. It is therefore their responsibility to provide liquidity, or they will lose control over the price. This is known as ‘pump and dump.
Why are liquidity pools important?
The value of a particular token is governed by the supply and demand for it, which is measured in terms of how many users are prepared to acquire the tokens and how much they are willing to pay for them.
As was discussed earlier, tokens that have a low possibility of being acquired by those who are holding Ethereum generally require buyers to provide a large amount of ETH. This has the potential to result in market manipulation.
Enable users to trade on DEXs:
Since DEXs rely on off-chain, peer-to-peer trading channels, liquidity pools are essential for allowing buyers and sellers to complete their transactions.
If a large number of users who support the same token were to decide to execute trades simultaneously, the system would be unable to cope with the demand.
Liquidity pools make it possible for smooth operations on DEXs, with significant benefits in terms of consumer experience and privacy. In addition, most DEXs do not have or need an order book due to their design. Without liquidity pools, this would make it impossible to conclude transactions.
Reduce the price volatility of tokens:
DEXs can execute trades without involving central parties. As a result, they are not vulnerable to the effects of monopolistic trading or market manipulation. This makes them a preferable option for users who want to acquire or dispose of tokens in the short term and for those who wish to trade small amounts of tokens with the minimal price change.
Eliminate middlemen and centralized entities:
DEXs eliminate trust-based systems and central authorities, thereby reducing the risk of theft or loss.
Provide financial benefits to token holders:
Decentralized exchanges do not have trading fees and do not charge users exorbitant amounts for the acquisition of tokens either. Fees are mostly limited to gas charges and transaction costs. This reduces or eliminates the need for users to pay high fees when acquiring tokens and allows them to trade tokens at a lower cost.
Uniswap, as a liquidity pool, provides users with a way to acquire the widest selection of tokens on the Ethereum network, thereby giving them direct access to a wider range of assets and allowing them to engage in more diverse trading strategies.
Purpose of liquidity pools
The liquidity pool is the medium through which traders execute their transactions. The purpose of the liquidity pool is to make trades possible, regardless of the liquidity that is currently available on the market.
Are there any risks associated with trading on Uniswap? Of course, there are always risks involved when you engage in cryptocurrency trading and this does not change just because you are using a DEX instead of a centralized exchange.
Top liquidity pools
Uniswap is one of the most innovative liquidity pools and boasts the highest liquidity. The pool has more than 200 traders, who are actively contributing to the pool to provide liquidity.
The traders contribute liquidity to the pool by withdrawing tokens directly from their ERC20-compatible wallets and subsequently depositing them in other wallets. These coins can then be used for trading on Uniswap or traded on any other platform that supports ERC20 tokens.
Uniswap is a decentralized and open-source exchange for ERC-20 tokens that enables a 1:1 trading ratio between Ethereum contracts and ERC-20 token contracts. Uniswap is unique and stands out as a well-known and highly valued platform for liquidity pools as a result of the large trade volume that it experiences.
There are no costs associated with launching new liquidity pools for any coin, therefore anyone can do it. The platform imposes a competitive trading fee of 0.3 percent, and liquidity providers are entitled to a portion of these fees proportional to the amount of cryptocurrency that they contribute to the pool.
The balancer is a highly reliable liquidity pool that excels at facilitating exchanges between tradable tokens and fiat currencies. The pool collects fees of 0.1 percent, which is a very competitive rate and the only way in which you can do this on Uniswap.
Traders who wish to trade on Balancer must deposit coins into their wallets, then transfer them to another wallet that can be used for trading purposes and finally send them to Balancer where they will be converted into a tradable token.
The balancer is an Ethereum-based liquidity pool that serves as a non-custodial portfolio manager and price sensor. Using Balancer, users enjoy the flexibility of customizing pools as well as earning trading fees by subtracting and adding liquidity.
The modular pooling protocol of Balancer allows it to support multiple pooling options, such as private, smart, or shared pools. In march 2020, the pool distributed BAL governance tokens to introduce a liquidity mining facility.
KeeperDAO is a non-custodial liquidity pool that provides its users with access to significant amounts of liquidity and unique features such as a specialist token called the KDAO token, which is used to execute trades on the platform.
Keepers have control over their own money and are free to participate in trading operations. However, they also need to deposit coins into their wallet to fund market orders.
The curve is one of the first liquidity pools launched on Uniswap, and it boasts significant liquidity with more than 200 traders actively contributing to the pool to provide users with the best possible trading experience.
The pool is a fully decentralized and open-source exchange that enables a 1:1 trading ratio between ERC20 tokens and ETH/ERC20 tokens. The curve is unique as it provides its traders with access to high liquidity, meaning that they can buy or sell large amounts of coins quickly, ensuring that their trades are executed quicker.
Bancor is one of the most popular liquidity pools and is well known for its Bancor Network Token, which is used to increase the efficiency and liquidity of token transactions.
The pool claims that it has a “liquidity reserve” that contains “well above 100 million dollars worth of BNT at all times”, however, it has yet to produce any evidence to support these quite significant claims.
Bancor is a decentralized exchange that operates on Ethereum and uses algorithmic market-making techniques in conjunction with smart tokens. Liquidity and precise pricing are both provided by the platform.
While adjustments are being made to the supply of tokens, a consistent ratio between the various related tokens is kept at all times. Bancor’s Relay liquidity pool has also developed a Bancor stablecoin to tackle the concerns associated with the fluctuation in liquidity.
It can handle liquidity pools using BNT tokens, ETH or EOS tokens, as well as the USDB stablecoin. Because it can leverage BNT to facilitate straightforward data movement between different blockchain networks, Bancor is widely regarded as one of the most successful liquidity pools currently in operation.
Bancor chargers do not impose a flat rate for exchange fees; rather, they charge a percentage of the transaction that can range anywhere from 0.1 percent to 0.5 percent, depending on the pool.
DEXs offer interesting solutions to a wide variety of problems, but they do come with several risks. However, DEXs can provide users with more security and privacy, which are sometimes linked closely with tokens. Using a DEX means that you become your bank account, which can be an attractive option for those who want to trade in large quantities.
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