Sep 8, 2022 at 11:10Contents
Today let’s discuss one of the main topics related to DeFi — the liquidity pool (LP). The concept is quite complicated, but we will simplify it as much as possible. We tell in this new article about the pros and cons and their purpose.
What is a liquidity pool?
The term is popular and on everyone’s lips, but newcomers to the industry may find it challenging to start using liquidity pools. The main reason is that the technology is still young, and the working principle is innovative.
Before explaining what a liquidity pool is, it would be to denote what liquidity is in general. In simple words, liquidity in economics is the ability of assets to be sold quickly and as close to the market price as possible. For example, money is considered a highly liquid asset because it can be rapidly exchanged for any other good or asset. What is regarded as a low liquid is something that cannot be sold quickly. For example, it could be an incomplete building or an expensive car.
In the crypto industry, the term means a vault that market participants fill with their assets. The purpose is to form a large liquidity reserve (stock of funds) for anyone who wants to exchange assets. In a usual financial system, the role of LP is performed by big banks, they manage depositors’ money, and they can even put new ones into circulation if they want.
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To make it even simpler. Liquidity pools in digital assets are tokens stored in a particular smart contract account. They are needed to provide trading and are widely used on DEXs. One of the first to work with liquidity pools was the Bancor project, but the concept developed on the Uniswap platform.
Liquidity pools vs. Order books
Many of you probably already know about crypto exchanges like Binance or KuCoin, where trading activity takes place using so-called order books. The idea is that buyers want to buy cryptocurrency at the lowest possible price, and sellers sell as expensive as possible. Someone has to give up and agree to someone else’s terms, but it happens that no one is willing to give in, or the number of tokens is less than the order’s satisfaction. To solve such a problem, there are so-called market makers.
Market makers must be willing to buy or sell any amount (as many as members of the community need) for a particular asset at any time, thus maintaining trading activity in the market. They earn because their “fair price” is slightly shifted in their favor, and the working principle is the same as at the usual exchange offices, i.e., the earnings are based on the difference between the buying and selling rates. Thanks to these market participants, ordinary users do not have to wait for a seller to appear for the cryptocurrency they want to buy. Both sides are in the gain.
How does a liquidity pool work?
The most common LP consists of two tokens, creating a new market for exchanging these cryptocurrencies. When a new pool appears, the first liquidity provider sets the starting exchange rate of cryptocurrencies within the pool. All providers must deposit the same amount of both tokens into the pool. A mismatch with current global prices could lead to arbitrage, during which liquidity providers could lose some of their funds.
After the coins enter the pool, the provider receives so-called LP tokens. Their number is proportional to how much liquidity the providers have provided. The exchange takes a commission of 0.3% of the transaction and distributes this amount between all pool participants in proportion to their share. By the way, this is another way to make money on digital assets — by providing liquidity. If a provider wants to get back the money invested from the pool, they need to burn all their LP tokens.
After each exchange with the liquidity pool, the exchange rate starts moving according to a special algorithm — the so-called automatic market maker.
Why is low liquidity a problem?
Low liquidity is a problem that can cause a big difference between the expected price of a cryptocurrency transaction and the price at which it takes place. Why does this happen? Because changes in coins in the pool after a swap or any other activity cause an imbalance when the pool contains insufficient coins. The trader will not experience much slippage when the pool is highly liquid.
However, high slippage is the worst-case scenario. If there is not enough liquidity for any trading pair on all protocols, users will be left with coins they cannot sell.
First, however, you need to understand how liquid cryptocurrency is. Many tokens that grow in value over a short period may not be liquid enough to sell later or have no liquidity. The problem is that newcomers to the market buy such tokens anyway, hoping to become millionaires. This is a mistake.
You can check how liquid a coin is by using special services. You can search for them on the expanses of the internet, but here are the ones we found.
If you work with cryptocurrencies based on the Binance Smart Chain blockchain, the following tools will help you:
To check Ethereum liquidity, you must replace the contract address with the token address in the MetaMask cryptocurrency search bar. Look for the latter at sites such as:
It’s worth mentioning that if the coins are already in the wallet, the customer can get the address from Etherscan by adding their wallet address there.
Information on all coins can also be found on Uniswap. The address of the desired cryptocurrency is located at the following link: v2.info.uniswap.org/token/address. The list of all coins on the Sushiswap platform can be found at this link: analytics.sushi.com/tokens.
Purpose of a liquidity pool
During a trade, the expected price and the execution price can be different. This happens everywhere, on both regular and cryptocurrency exchanges. LP can solve this problem by providing incentives to market participants and liquidity at a fraction of the trading fees.
For some trades, such as on Uniswap, there is no need to compare the expected value and execution price. The automated market makers we wrote about above facilitate transactions by bridging the gap between buyers and sellers of digital assets. Thus, trades on DEX are both simple and reliable.
Regulation of liquidity pools
You need a license to create a liquidity pool. Also, wherever an LP is sold or promoted, you need an investment fund license, no matter its jurisdiction. Some LPs issue management coins and pretend they belong to the community, thereby circumventing the problem. Even if they wanted to, regulators can’t prosecute fund owners in court because the property belongs to the community as a whole. It is true that by participating in such pools, funds take many risks.
Popular liquidity pool providers
Many DeFi-platforms work with automatic market makers. Recall that they can trade cryptocurrencies automatically and without permission. Among the leading platforms that specialize in transactions with LPs are:
- Uniswap. On it, you can exchange Ethereum for any other ERC-20 token. No centralized service is needed. It is an open-source platform where you can run an exchange pair directly on the network for free.
- Curve. Decentralized LP for stablecoins on ETH. Allows for less slippage because stablecoins are not volatile.
- Balancer. Gives several merger options – private and general LPs. Offers several advantages for liquidity providers.
Liquidity pools: pros and cons
Pros:
- with LPs, it is easier to trade on decentralized exchanges because it is possible to perform transactions at market prices here and now;
- gives liquidity to users, also giving them rewards in the form of interest or annual percentage income on their digital asset;
- operates on conventional smart contracts available to all, providing transparency in security valuation data.
Cons:
- LP is controlled by a small group, which goes against the principles of decentralization;
- not suitable security protocols increase the possibility of a hacker attack, which can hurt liquidity providers;
- vulnerability to scammers, who often use a scheme such as rug pulls and exit scams;
- there is a risk of not getting back what is lost; this happens when the value of all the coins locked into the LP changes and creates a non-existent loss compared to if the money was in the wallet.
The future of liquidity pools
Attracting liquidity is tricky, especially given the competition in the environment, moreover when you consider investors who periodically look for high returns elsewhere and take the liquidity away.
According to analytics platform Nansen, just over 40% of farmers who provide liquidity to the pool on its creation leave the pool within a day. On the third day, only 30% of them remain. This is a problem called “mercenary capital.” OlympusDAO conducted an experiment with liquidity that belongs to the protocol. Instead of launching a pool, the organization’s experts allowed users to sell digital assets to the treasury. They had to give the protocol token at a discounted stablecoin OHM. The unique thing was that players could bet on OHM, which could generate high returns.
However, something went wrong: investors wishing to cash in coins questioned the protocol’s reliability. Therefore, nothing will change for LPs until decentralized finance resolves something about the transactional nature of liquidity.
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