What Are Liquidity Pools In Defi & How Do They Work?

DeFi is the new technological development that aims to shake up traditional financial systems. Its goal is to create a permissionless and open-sourced financial system eliminating the “middle person” and costs associated with intermediaries such as banks. They provide financial services typically restricted to centralized exchanges, such as trading, lending, savings and more – but in an entirely permissionless manner. To achieve this, DeFi Apps rely heavily on the technology of smart contracts and liquidity pools.

What is a liquidity pool in DeFi?

Liquidity is essential in any financial market and for all tradable assets but within cryptocurrency, we can define it as the ability of a coin to be easily converted into cash or another coin.  

Centralized exchanges rely heavily on market makers to provide liquidity to their markets. Market makers are traders who are willing to “make” the market, that is, buy and sell large quantities of assets at various prices to ensure the market remains liquid and orders are continuously fulfilled on the exchanges. Market makers may be institutions or seasoned, well-capitalized traders (“whales”) and without them, the market is at risk of being illiquid. A market might be illiquid because there isn’t enough demand or supply of a given asset, particularly dangerous since it leads to price volatility – often referred to as slippage. 

Most platforms that offer financial services want to avoid slippage. That’s because if consumers can’t trade what they want, at the price they want, they may go elsewhere, like to an exchange with greater liquidity, one that can accommodate more trades, without moving the price too much, and resulting in a better trading experience.

On traditional centralized exchanges, market makers provide liquidity by continuously trading pairs via the order book. Such exchanges provide the order book model via an electronic order tracking system that automatically matches the best possible pair of buy/sell orders. Such a system is known as a matching engine. Until the order is fulfilled, one can change orders to the order book, without any cost. This is important, since market makers may often cancel, or create new orders, in accordance with price changes.

In contrast however, DeFi Apps execute all trades on-chain via the underlying blockchain smart contract. For example, Ethereum ECR-20 is known for powering the smart contracts that serve a great majority of DeFi Apps. It does this through its easily applicable code – solidity. Importantly, though, every interaction in a smart contract creates a gas fee, and as a result, an encumbrance for would-be market makers; they would find it costly to continuously make the market liquid when interacting with an on-chain order book. Costly gas fees, as well as slow block confirmations, would make the process of creating and readjusting large buy and sell orders all but impossible. 

However, liquidity is still needed in DeFi Apps to enable users to purchase, swap and trade coins. So how do they achieve this despite the concerns laid above? 

Well, this is where liquidity pools come in, to act as automated market makers.

How do liquidity pools work in DeFi?

Liquidity pools are pools of tokens locked in a smart contract. Typically, they hold two tokens and each pool indicates a new market for that particular pair of tokens. Liquidity pools act as Automated Market Makers (AMMs) helping to keep the market liquid, supplying the locked assets to trades when needed (via smart contracts) and in doing so allowing consumers to trade coin pairs without great price effect. All liquidity providers must supply an equal value of each token in the pool so that the price of tokens in the pool does not diverge from the global market price. If so, this will result in arbitrage and a loss of capital for the liquidity providers. A popular pool is the DAI/ETH pool on UniSwap which currently has a market cap of approximately $89 million. If you wanted to join this pool and supply e.g. 0.5 ETH, you must also supply the equivalent of that in DAI to keep the pool ratio 1:1.  

Currently, there is approximately $83 billion locked across various DeFi Apps, so there must be some sort of incentives to explain such value. Well, when one joins a liquidity pool, these funds will actually be traded. For example, if someone wants to swap lots of DAI for ETH on UNISWAP, then your contribution to the DAI/ETH pool might be used to facilitate this for the market. Importantly, every trade that is made using your funds in the pool incurs a fee on the traders, for example UNISWAP charges a 0.3% fee on all trades. These fees are then proportionally distributed amongst all the Liquidity pool providers. The more you supply to the pool, the more fees you earn since you are supporting more trades in that market.

Even more so, many DeFi apps started to offer on top of the fee distribution to pool providers, liquidity pool token distribution. This is an incentive used by various DeFi platforms to get people to provide liquidity to their app. For example, Balancer began distributing BAL tokens to users who contributed to some of their liquidity pools. The trading price of the asset (BAL) as of this writing is approximately $25. Such incentives can be quite successful, especially if the price of the distributed token appreciates; those who are the recipients of distributed tokens (in this example, $BAL Balancer tokens) will earn via two streams, from the trading fees as well as any appreciation of the tokens. Additionally, the pool tokens can then be used within the app (to swap, trade or stake) or sent to other DeFi Apps.

Now, it’s probably not so surprising to see why many might prefer to use this new model of a “savings” account. In traditional finance, low APYs and negligible returns in saving accounts have caused many people to feel left behind by the system. DeFi app pools, on the other hand, can carry greater APYs, offering true “savings” to more people, efficiently and transparently. people in a more.

However, despite these benefits DeFi pools aim to facilitate, there’s nothing especially technology, that is entirely perfect. And in exchange for the possibility of high returns, comes the high risk involved when engaging with DeFi apps, cryptocurrency markets and smart contracts as a whole. 

Risks involved with DeFi Liquidity Pools

1. Volatility – it’s important to remember cryptocurrency markets are still very volatile and market fundamentals such as industry news and regulation can result in a sudden change in the price of both your locked asset and distributed tokens. This means that the return you gain in fees might, in the end, be outweighed by the devaluation of assets in the pool.
2. Impermanent loss – is a temporary loss of funds when providing liquidity. It’s only temporary since the loss isn’t actualized unless you withdraw the assets from the pool. In short, impermanent loss occurs since the total ratio of tokens in the pool have to equal zero and when one of the assets in the pool is more volatile than the other. In more stable liquidity pools, where prices are similar and volatility is less present, an impermanent loss is less likely to occur.
3. Bugs – Whilst smart contracts indicate an impressive technological revolution, there’s a possibility that they can be hacked. Smart contracts are constantly being audited and improved upon by developers but even this can’t eliminate risk completely. Incidents like that of SafeDollar remind us why it is important to never supply your essential funds to pools. That goes for investing in general. Stick to the golden rule: only invest what you can afford to lose. 
4. Systemic Changes – DeFi Apps are still subject to system and platform upgrades. For example, there’s still a possibility that, say, an Ethereum platform upgrade could potentially cause smart contracts to act in some unintended way, or somehow lead to your funds not being accessible when you need them. This is just a risk that cannot be entirely eliminated in technology and it also begs the question as to just how decentralized such exchanges can be.

In Summary:

DeFi Apps aim to offer financial products and services traditionally limited to centralized finance e.g. banks, in a more accessible way by facilitating services such as purchasing, swapping assets. Liquidity is needed and liquidity pools provide this support acting as automated market makers. 

In return for entering into a liquidity pool, pool providers are then paid a proportion of the fees taken to facilitate the trades. DeFi Apps also sometimes provide as a further incentive, LP tokens for entering a pool, and with the right Liquidity Pool token can be profitable if it does appreciate in price.

However, as we’ve discussed, this is never guaranteed and you should always do your own research whenever interacting with volatile markets and technology related to cryptocurrency.