What is a Liquidity Pool?

Liquidity Pool Cover Diagram

Short Answer

Liquidity Pools are crowd-sourced collections of digital assets locked in a smart contract. They support DEXs by providing liquidity for traders to swap between currencies.

Users who supply assets to a Liquidity Pool are financially rewarded for providing liquidity.

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Liquidity pools serve as a functional pillar to the workings of Decentralized Finance (DeFi). Essentially, liquidity pools are a collection (pool) of tokenized assets through which traders and investors can buy and sell those specific assets (liquidity). The funds are locked within a smart contract and an algorithm manages the automated transactions (Automated Market Maker (AMM)) of assets for buyers and sellers within that specific liquidity pool.

To better understand the value and utility of liquidity pools, let’s consider how buying and selling occurs within a centralized exchange (like Coinbase, Kraken, FTX, etc.) and traditional stock exchanges (NYSE, Nasdaq, etc.) using the standard Order Book Model.

Traditional Order Book: A Simple Diagram

In the context of an order book model, a Market Maker facilitates trades by providing liquidity; platform users (buyers and sellers) rely on the market maker’s liquidity to process their orders rapidly and efficiently. Throughout this process, however, vast amounts of buy and sell orders are being created, triggered — and cancelled. This style of order processing is not a viable solution for blockchains, primarily due to:

  • transaction speed (far too many orders to place, process, or cancel)
  • gas fees would be cost prohibitive for market makers to justify participating
  • relying on a sole market maker is not particularly decentralized

To solve this problem, and keep the nature of these financial transaction processes more decentralized, the Liquidity Pool and, subsequently, the Automated Market Maker (AMM) was created. AMMs are DEX protocols that rely on algorithms to price assets and facilitate trades. They leverage funds from the Liquidity Pools to do so.

Liquidity Pools: A Simple Diagram

Think of traditional order books as a type of centralized or peer-to-peer (P2P) tool, and an automated market maker as a decentralized tool or “peer-to-contract” (P2C) model. Through an AMM, a user (buyer or seller) makes a trade directly with the protocol via the Liquidity Pool.

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Why do investors become Liquidity Providers?

AMMs / DEXs rely on liquidity provided by users looking to earn on their loaned assets via the Liquidity Pool. Users who add their assets to the pool are called Liquidity Providers (LPs). Typically, liquidity providers are given LP tokens in return for adding liquidity to the pool. These LP tokens act as a “receipt” and can be exchanged by the user (then burned by the protocol) for the original assets deposited, plus any fees or other rewards earned during that period.

LP token holders are (typically) given LP tokens proportionate to the amount of liquidity they have supplied to the liquidity pool. Trading fees processed by the DEX from that particular liquidity pool are then (typically) paid out proportionately to all LP token holders.

Liquidity Providers can also use their LP tokens in other DeFi strategies to earn more yield depending on the user’s risk appetite, investment horizon, and general DeFi experience level.

Opportunities of Liquidity Pools

Trading Fees

Rates vary, but many any DeFi protocols charge a trading fee of approximately 0.3%. This fee is paid proportionately to the LP Token holders. New protocols may charge a lower fee to attract users.

Liquidity Mining

Sometimes, DeFi protocols will offer additional incentives for users to retain (and encourage new) participation and attract new liquidity. An example of these incentives may be providing higher return or higher rewards for particular liquidity pools; encouraging existing LP Token holders to keep their investments, and/or add more with the opportunity of higher earnings. This is particularly attractive to investors who want higher returns on a specific asset or asset pair.

Yield Farming

Another incentive for DeFi investors, the basic principle of yield farming involves staking tokens within a particular DeFi protocol to earn additional rewards. A simple example of this would be earning that DeFi protocol’s own, native token. DeFi users can compound the effects of yield farming depending on their experience levels and risk appetite. It’s important to know that yield farming adds a layer of complexity and increased risk for DeFi investors.

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TOOLS IN BETA

Build a data-driven,profitable,multi-chain,balanced

DeFi portfolio.

track 65,000+ liquidity pools
visualize liquidity pool token prices
get additional performance metrics
spot new opportunities in real time
add multiple wallets to your account

Risks of Liquidity Pools

Impermanent Loss

Put simply, impermanent loss (IL) reflects the $USD value loss in your holdings via the Liquidity Pool compared to your financial profit (or loss) had you simply held the assets in tokens, vs. adding them to the liquidity pool.

Said another way:

Impermanent loss occurs when the price ratio of the tokens a liquidity provider deposits in a liquidity pool change after they are deposited. It’s called “impermanent” because the ratio can return to the original amount if a user leaves the assets in the pool — the change becomes permanent when a liquidity provider removes funds from the pool.

The concept of Impermanent Loss can be rather complex. See our resource that focuses specifically on this topic to learn more.

Smart Contract Risk

Through decentralized finance, users are technically protected from having their assets managed my middlemen or other unknown figures, but funds are still guarded and “ruled” by the code within the smart contract. If the smart contract has vulnerabilities that are exploited, an LP and/or user’s funds may be lost forever.

Slippage

Slippage is the difference between an asset’s expected executed trade price, and the actual executed trade price. Users experience the negative effects of slippage when using DEXs / Liquidity Pools with low levels of liquidity for their desired trading pair(s).

Traders or investors that have large order sizes are better off using popular DEXs with the highest liquidity to ensure the lowest possible slippage.

Misuse of Administrative Access / Keys

Sometimes, developers might have privileged access to the smart contract code. This presents an opportunity for malicious actors to take control of the funds / rug pull / exit scam. It’s important that DeFi investors do their research before placing assets in unknown DeFi protocols.

Binance Academy offers a beginner-level article on spotting scams in DeFi. Read it here.

Overall Market (Systemic) Risk

As with any new technology, investors in DeFi must stay vigilant of macro-economic, political, and industry events and general market momentum. Industries like DeFi often react more heavily than traditional markets, leading to increased volatility in cryptocurrencies. Always be aware of risk and manage it appropriately based on your own financial situation.

Information contained on this website and in this article are for informational and entertainment purposes only. Yield Monitor does not offer financial, investing, or trading advice. Yield Monitor does not endorse any of the products, tools, or services mentioned in this article. Yield Monitor does not guarantee the reliability or accuracy of this content and shall not be held liable for any errors, omissions, or inaccuracies. Decentralized Finance (DeFi) is rapidly evolving; all readers are encouraged to regularly do their own research and consult a financial professional before making any investment decision. Learn more in our Terms of Service.

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