What is a Liquidity Pool?

1 Nov 2023 by Harry Newman 5 min read

Liquidity Pools are essential for DeFi, offering users the ability to trade, invest and earn rewards in a trustless, decentralised manner.

Smart contracts help to create a Liquidity Pool that is used on decentralised exchanges. Liquidity Pools are designed to incentivise investors to earn passive income on cryptocurrencies that would otherwise be idle by adding liquidity to decentralised exchange platforms like Uniswap.

We will go into further detail about Liquidity Pools below.

What is a Liquidity Pool?

Liquidity Pools are a foundational part of DeFi, they are decentralised pools of funds provided by users of the blockchain to facilitate decentralised exchange services such as swaps, borrowing, lending and earning interest on assets.

In exchange for this users of the Liquidity Pool receive rewards for providing liquidity.

Liquidity Pools ensure that there is enough liquidity for that token on a decentralised exchange by locking up those funds in a pool, users who provide tokens to the smart contract are called liquidity providers (LPs) and anyone can do this.

An exchange such as Uniswap requires traders who buy and sell crypto on the platform to pay a trading fee, this fee is distributed to Liquidity Providers as a reward for providing liquidity to the platform.

The emergence of Liquidity Pools provides an innovative and automated way of solving liquidity challenges on a decentralised exchange. Orders are fulfilled from the Liquidity Pools.

Replacing the traditional order book model used by centralised exchanges and legacy financial markets.

Legacy finance has to pair a buyer with a seller before a transaction can be completed, whereas DeFi platforms can automatically execute a trade with the liquidity from the pool on the platform.

You can find a list of the top Liquidity Pools here.

How Do Liquidity Pools Work?

Liquidity Pools operate without any intermediaries, making them decentralised, this is achieved through smart contracts.

Within a Liquidity Pool, there are two or more assets that are paired together, creating a trading pair.

Liquidity Pools often use Automated Market Makers to determine asset prices and execute trades.

DeFi liquidity, the amount of cryptocurrency locked in a smart contract, is expressed in terms of total value locked or TVL, platforms with a higher TVL are considered to have more potential for growth than platforms with lower TVL.

Impermanent Loss (IP) is a risk that can occur when providing Liquidity to an AMM on a DeFi exchange like Uniwap.

IP occurs when you provide liquidity to a liquidity pool, and the price of your deposited assets changes, by decreasing in value, compared to when you deposited it.

The types of rewards a liquidity provider receives depend on the type of platform the pool is on, for example, on a DEX like Uniswap, the liquidity provider will receive a share of the trading fees.

On a lending platform such as Compound, a user will receive a share of the interest received from the borrowers.

Other use cases for Liquidity Pools include yield farming by earning rewards by supplying assets to DeFi pools, Cross-chain liquidity, bridging liquidity across different blockchain networks, and governance/voting rights for being a liquidity provider just to name a few.

Pros and Cons of Liquidity Pools

Pros

Liquidity providers can earn a share of trading or lending fees generated by the pool, offering passive income.
Liquidity Pools are decentralised, with no reliance on any intermediaries.
Open to anyone with an internet connection, users can have access to DeFi without the need for a bank account or ID verification.
Liquidity Pools help DeFi platforms function by helping to provide liquidity.

Cons

Impermanent Loss can occur when the price of the asset in the pool changes significantly from the initial deposit.
The smart contracts powering the Liquidity Pools are vulnerable to exploits and hacks that can result in loss of funds.
Assets within a pool are subject to price fluctuations, which can impact the value of the investment.
Despite being open to all, the technology and concepts can be complex, which can cause a barrier to entry for some users.

Example of Investing in a Liquidity Pool

Let's use the example of an individual, Simon, who decides to invest $10,000 in a Liquidity Pool. Simon is interested in earning passive income by providing liquidity for the DeFi platform Uniswap.

Simon first selects a pair for the Liquidity Pool, he chooses ETH and a stablecoin token, DAI to provide liquidity.
Simon deposits $5,000 worth of ETH and $5,000 worth of DAI into the liquidity pool, in return he will receive liquidity pool tokens representing his share of the pool.
As users trade against the liquidity pool, Simon earns a portion of the trading fees, proportional to his share of the pool, if the trading volume is high, Simon can earn significantly more.
Simon can regularly check the pool performance and the amount of fees he has earned, over time he notices that the price of ETH has increased dramatically relative to DAI, which can result in impermanent loss, the trading fees earned help to offset his losses.
Simon decides to withdraw from the liquidity pool, he receives his initial investment, plus any trading fees he has earned during his time as a liquidity provider.

Final Thoughts

Liquidity Pools are the cornerstone of DeFi, offering a dynamic and versatile way for users to participate in the crypto ecosystem.

This can all be done through the use of smart contracts, without relying on any intermediaries.

Whilst Liquidity Pools offer good advantages for liquidity providers they also come with challenges, impermanent loss and any smart contract vulnerabilities will always be a reason for users to understand the risks involved.

As DeFi evolves Liquidity Pools will likely remain an important part of reshaping how individuals interact on the blockchain.

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