What are liquidity pools in DeFi?

Liquidity pools are the lifeblood of most modern-day decentralized finance (DeFi) protocols. They enable many of the most popular DeFi applications (dApps) to function and offer a way for crypto investors to earn a yield on their digital assets. But what are liquidity pools and why do they play such an essential role in DeFi?

What is a liquidity pool?

Liquidity is the ability of an asset to be sold or exchanged quickly and without affecting the price. In other words, liquidity is a measure of how easily a purchase can be converted into cash.

A liquidity pool is a collection of digital assets accumulated to enable trading on a decentralized exchange (DEX). A DEX is an exchange that doesn’t rely on a third party to hold users' funds. Instead, DEX users transact with each other directly.

DEXs require more liquidity than centralized exchanges, however, because they don't have the same mechanisms in place to match buyers and sellers. They use Automated Market Makers (AMMs), which are essentially mathematical functions that dictate prices by supply and demand.

Liquidity pools are an essential part of decentralized exchanges as they provide the liquidity that is necessary for these exchanges to function. They are created when users lock their cryptocurrency into smart contracts that then enable them to be used by others — a bit like how companies transform money into debt or equity via loans.

You can think of liquidity pools as crowdfunded reservoirs of cryptocurrencies that anybody can access. In exchange for providing liquidity, those who fund this reservoir earn a percentage of transaction fees for each interaction by users.

Without liquidity, AMMs wouldn’t be able to match buyers and sellers of assets on a DEX, and the whole system would grind to a halt.

What is the purpose of liquidity pools?

The primary goal of liquidity pools is to facilitate peer-to-peer (P2P) trading on DEXs. By providing a steady supply of buyers and sellers, liquidity pools ensure that trades can be executed quickly and efficiently.

Most people prefer using liquidity pools as a financial tool to participate in yield farming (also called “liquidity mining”). Simply put, yield farming is the process of providing liquidity to a pool to earn a portion of the fees that are generated from trading activity.

How do liquidity pools work?

Liquidity pools are created when users (called liquidity providers) deposit their digital assets into a smart contract. These assets can then be traded against each other on a DEX.

When a user provides liquidity, a smart contract issues liquidity pool tokens (LPTs). These tokens represent the liquidity provider's share of assets in the pool.

Why are liquidity pools important?

Liquidity pools are at the heart of DeFi because peer-to-peer trading isn’t possible without them. Below are a few reasons why liquidity pools play such an important role.

Liquidity pools enable users to trade on DEXs

Liquidity pools provide the liquidity that is necessary for decentralized exchanges to function. Without them, it would be very difficult to trade digital assets on a DEX.

Liquidity pools provide the liquidity that is necessary for decentralized exchanges to function by allowing users to deposit their digital assets into a pool, and then trade the pool tokens on the DEX.

Liquidity Pools eliminate middlemen and centralized entities

Liquidity pools use Automated Market Makers (AMMs) to set prices and match buyers and sellers. This eliminates the need for centralized exchanges, which can greatly increase the privacy and efficiency of all commerce activities.

Liquidity providers get incentives

Liquidity pools pave a way for LPs to earn interest on their digital assets. By locking their tokens into a smart contract, users can earn a portion of the fees that are generated from trading activity in the pool.

This provides an incentive for users to supply liquidity to the pool, and it helps to ensure that there is enough liquidity available to support trading activity on the DEX.

Are liquidity pools safe?

Liquidity pools have become increasingly popular and there is a growing amount of capital being deployed to them. As a result of increasing adoption and growing stakes, more people are involved than ever before to safeguard users’ funds through well-coded smart contracts.

Still, there are a few risks that you should know about.

Bugged smart contracts

One of the biggest risks when it comes to liquidity pools is smart contract risk. This is the risk that the smart contract that governs the pool can be exploited by hackers.

If hackers can find a bug in the smart contract, they can theoretically drain the liquidity pool of all its assets. For instance, a hacker could borrow a large number of tokens by taking a flash loan and execute a series of transactions that would eventually result in the funds draining, which is what happened in the 2020 flash loan attack on the Balancer protocol.

This is why it's highly recommended to only invest in liquidity pools that have been audited by a reputable firm, thus reducing the likelihood of engaging with a vulnerable smart contract. 

High slippage due to low liquidity

Another risk to consider is low liquidity. If a pool doesn't have enough liquidity, it could experience high slippage when trades are executed.

What this essentially means is that the price difference between the performed transaction and the executed trade is large. This is because when the liquidity pool is small, even a small trade greatly alters the proportion of assets.

Most DEXs allow you to set slippage limits as a percentage of the trade. But keep in mind that a low slippage limit may delay the transaction or even cancel it.

Frontrunning transactions

Another common risk is frontrunning. This occurs when a user tries to buy or sell an asset at the same time that another user is executing a trade.

The first user can buy the asset before the second user and then sell it back to them at a higher price. This allows the first user to earn a profit at the expense of the second user.

Impermanent loss

Impermanent loss is the most common type of risk for liquidity providers.

It occurs when the price of the underlying asset in the pool fluctuates up or down. When this happens, the value of the pool's tokens will also fluctuate.

If the price of the underlying asset decreases, then the value of the pool's tokens will also decrease.

The reason this is considered a risk is that there is always the potential that the price of the underlying asset could decrease and never recover. If this happens, then the liquidity provider would experience a loss.

An impermanent loss could also occur when the price of the asset increases greatly. This causes the users to buy from the liquidity pool at a price lower than that of the market and sell elsewhere. If the user exits the liquidity pool when the price deviation is large, then the impermanent loss will be “booked” and is therefore permanent.

Conclusion

Pros and cons of liquidity pools

Pros

• Simplifies DEX trading by performing transactions at real-time market prices.
• Allows people to provide liquidity and receive rewards, interest, or an annual percentage yield on their crypto.
• Uses publicly viewable smart contracts to keep security audit information transparent.

Cons

• The pool of funds is under the control of a small group, which is against the concept of decentralization.
• Risk of hacking exploits because of poor security protocols, causing losses for liquidity providers.
• Risk of frauds such as rug pulls and exit scams.
• Exposure to impermanent loss. This happens when the price of your assets locked up in a liquidity pool changes and creates an unrealized loss, versus if you had simply held the assets in your wallet.

Frequently Asked Questions (FAQs)

Can you make money with liquidity pools?

Yes, you can make money by providing liquidity to a pool. This is because you will earn fees whenever a trade is executed in the pool.

What is a good liquidity pool?

A good liquidity pool has been audited by a reputable firm, has a large amount of liquidity, and high trading volume.

It's also important to consider the fees associated with the pool as well as the risks involved.

The redistribution of the fees to liquidity providers should be large and the protocol should ideally have mechanisms in place like protection against impermanent loss and on-chain insurance to protect liquidity providers.

When is it a good time to exit a liquidity pool?

It's generally a good idea to exit a liquidity pool when the price of the underlying assets in the pool starts to become very volatile. This is because the risk of impermanent loss becomes greater when the prices of the assets in the pool fluctuate greatly.