Liquidity Pools: Everything to Know

By  Beluga Research September 10, 2023

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Summary

  • A cryptocurrency liquidity pool is a shared pool of digital assets locked in a smart contract, which facilitates trading by providing liquidity for decentralized exchanges (DEXs)
  • Liquidity pools enable trading and lending activities in the decentralized finance (DeFi) ecosystem
  • The platforms compensates users that put assets in liquidity pools with trading fees
  • Liquidity pools use automated market maker (AMM) algorithms to determine asset prices

Overview

A cryptocurrency liquidity pool is a shared pool of digital assets locked in a smart contract, which facilitates trading by providing liquidity for decentralized exchanges (DEXs). A liquidity pool provides liquidity for smooth and efficient trading. Liquidity pools make it easier for DEXs to function. They offset the inherent illiquidity of DEXs.

A Brief History

Liquidity pools gained prominence with the rise of DEXs in the crypto space. Bancor was the first DEX to introduce liquidity pools, in 2017. In 2018, Uniswap utilized liquidity pools. Uniswap introduced the AMM algorithm. This algorithm allows users to trade ERC-20 tokens directly from their wallets, using liquidity provided by other participants in the pool. Later, more DEXs began to use liquidity pools, including SushiSwap and Curve. A liquidity pool can contain other tokens beyond ERC-20 tokens. For example, BurgerSwap contains Binance's BEP-20 tokens.

Liquidity Pools: Everything to Know

The three key features of liquidity pools are the way in which a pool is created, the users behind the pool, aka the liquidity providers and the pool's trading mechanism.

  • Pool Creation : Users create liquidity pools by depositing an equal value of two different tokens into a smart contract. These tokens are typically paired together, like Ether (ETH)/DAI. The deposited tokens form a reserve for trading.
  • Liquidity Providers: Individuals who contribute funds to liquidity pools are liquidity providers. When liquidity providers deposit tokens, they enable other users to trade against their liquidity. Liquidity providers receive a portion of the trading fees as compensation.
  • Trading Mechanism: Liquidity pools use the AMM model for trades. Instead of an order book, AMMs utilize algorithms. The algorithms determine asset prices based on the token ratio in the pool. When a user wants to trade, the AMM algorithm calculates the new token ratio to maintain the pool's overall value.

Getting Started

A liquidity pool is a smart contract that holds a reserve of two or more tokens. These tokens can be any pair of cryptocurrencies, like ETH and a stablecoin such as Tether (USDT). Participants contribute an equal value of both tokens to the liquidity pool. They receive liquidity pool tokens in return. These tokens represent their share of the pool. Users can redeem the tokens for a proportional share of the underlying assets.

Temporary losses. Users experience temporary losses when the token price in the pool changes compared to the token price at the time of the deposit. Users can offset these losses by earning trading fees for locking their tokens.

Expansion beyond token swaps. As of 2023, many lending protocols of liquidity pools allow users to earn interest on the tokens locked by the smart contract.

Unique Aspects

AMM algorithms . AMMs use mathematical formulas to determine asset prices within the pool. The most common AMM algorithm is the constant product or x*y=k formula, which was popularized by the Uniswap protocol.

Under the constant product formula, the product of the reserve balances of the two tokens in the pool remains constant. When a user wants to trade one token for another, they send their tokens to the liquidity pool. The AMM algorithm for the pool adjusts the reserve balances accordingly. This change in reserves affects token prices. It ensures that larger trades result in slippage. It also discourages price manipulation.

Liquidity providers . Users' deposit of tokens into a liquidity pool enables trading. Users receive fees for providing their coins. The fees are generated whenever someone trades against the pool. A user's fee is proportionate to their share of the pool.

Temporary losses. These occur when the price of a token in the pool significantly diverges from its initial value at the time of deposit. Liquidity providers are exposed to this risk because they bet on the relative price stability of the tokens in the pool. If the price of one token sharply rises or falls, liquidity providers experience losses.

Advantages

  • Enhanced Liquidity: Liquidity pools increase liquidity in DeFi. This is because they pool the funds of multiple participants. This ensures there are sufficient assets for trading and transactions.
  • Market Efficiency: Liquidity pools improve market efficiency. They narrow the bid-ask spread as more participants join. This benefits traders with better prices. It also reduces slippage risk.
  • Accessibility: Liquidity pools enable anyone with assets to participate in DeFi. Users contribute tokens to a pool and earn a portion of transaction fees. This empowers users who have little to no access to traditional financial institutions, such as banks.
  • Flexibility: Participants can join or exit a pool anytime. This allows them to manage their positions according to preferences and market conditions.
  • Automated Market Making: Liquidity pools use AMM algorithms to determine asset prices based on supply and demand. This eliminates intermediaries. Since the crypto ecosystem operates 24-7, AMM algorithms also enable continuous trading.

Disadvantages

  • Impermanent Loss: Liquidity providers face temporary loss when asset prices deviate from the initial ratio. Withdrawals may result in losses if an asset's price significantly increases compared to that of other assets.
  • Smart Contract Risks: Liquidity pools rely on smart contracts, which can have vulnerabilities and bugs. Exploits can lead to fund loss or price manipulation. This exposes participants to risks.
  • Limited Control: Participants relinquish control over their assets to the pool's smart contract. Price determination is influenced by market forces and automated algorithms.
  • Imperfect Pricing: Prices within a liquidity pool may deviate from the broader market due to low liquidity, manipulation attempts and price update delays. Relying solely on pool prices can hinder executing trades at expected market prices.
  • Regulatory Uncertainty: Regulations for DeFi and liquidity pools are still evolving. They also vary across different countries. Participants may face legal and compliance concerns because of regulatory uncertainty.