What Are Liquidity Pools And Why Do They Matter?

The decentralized finance industry offers many intriguing aspects that may not make sense at first. Liquidity pools, for example, can be a good source of income but are not without risk.

Table of contents

  • The Liquidity Pool Concept
  • A Core Pillar Of Decentralized Finance
  • How Does It Work?
  • Orders Book Aren’t Liquidity Pools
  • Scalability Remains A Concern
  • Not Peer-to-Peer Trading
  • Other Use Cases For LPs
  • The Potential Risks Of Liquidity Pools
  • Closing Thoughts

The Liquidity Pool Concept

Of the many decentralized exchanges in the cryptocurrency world today, most of them use an AMM model. AMM stands out Automated Market Maker, creating a way for users to swap between different cryptocurrencies directly from their wallets. Popular platforms offering this functionality include Uniswap, Sushiswap, PancakeSwap, and so forth.  The concept is prevalent in the industry, as it provides some benefits to users.

Rather than just cater to traders, many people use AMM decentralized exchanges for their liquidity pools. By engaging with this functionality, users can contribute their crypto-assets to a pool and earn a share of the trading fees in exchange. It is a viable system that benefits both the AMM DEX and the liquidity providers, assuming the markets do not head in the wrong direction. 

Without liquidity pools, it would be a lot more complex to exchange crypto-assets on decentralized exchanges. As these platforms are non-custodial, there is no way of depositing funds without executing an order. Everything is handled by smart contracts, removing all intermediaries from the equation. 

A Core Pillar Of Decentralized Finance

Whereas the liquidity pool concept mixes well with decentralized exchanges, it also becomes essential in the DeFi segment. Decentralized finance can benefit from liquidity pools to create a yield farming approach. It works very similarly to a DEX pool, but it is a self-hosted solution to keep liquidity within the project’s ecosystem. 

While one has to commend the liquidity pool approach in DeFi it also creates a risk. As value remains locked within a closed ecosystem, users no longer control their funds and are exposed to price fluctuations. Although the rewards for exploring this option are often far better than earning trading fees on a decentralized exchange, one cannot ignore the risks either. 

How Does It Work?

To provide liquidity in DeFi, one usually has to own the native platform’s asset. Acquiring this token happens by buying it on an exchange or participating in a token sale. Some platforms may even airdrop tokens, although that is becoming a rare occurrence these days. Trading these DeFi tokens on a DEX is often the best approach, assuming there is a reason to invest.

For decentralized exchanges, liquidity pools work a bit differently. Although it too requires committing funds, users have to provide both assets in a trading pair to be considered “eligible” for rewards. On Uniswap, for example, users can pool liquidity for ETH/USDT. To receive rewards, every provider needs to supply an equal value in ETH and USDT to the pool. 

Everyone who provides liquidity on a decentralized exchange will receive Liquidity provider (LP) tokens. By owning these tokens, users earn passive revenue through trading fees for the pool they engage with. Anyone can become a liquidity provider in the decentralized world, assuming they have the correct asset(s) for the platform of choice. 

Today, several protocols use liquidity pools. Bancor, Uniswap, Sushiswap, Curve, Balancer, and BurgerSwap are just some examples. Every DeFi platform implements this option differently, although the core idea remains the same across the board. It will be interesting to see if developers come up with ways to improve upon this concept. Removing some of the risk factors should be the first order of business. 

Orders Book Aren’t Liquidity Pools

There may be a strong correlation between centralized exchange’s order books and a DEX’s liquidity pool to the untrained eye. In reality, they are very different from one another. 

Any platform leveraging liquidity pools is not maintaining an order book, as there is never a list of buyers and sellers. Order books collect the open orders for any given market, yet liquidity pools only depict how many assets are in the pool, allowing users to purchase at current market prices. 

Second, maintaining an order book is only possible through a trading engine capable of matching buyers and sellers. Liquidity pools have no matching engines, yet that doesn’t mean exchanging cryptocurrency is any less efficient. One downside to not having an order book is how decentralized exchanges will – probably – never support fiat currency conversions. 

Third, the use of centralized exchanges means depositing funds to the platform and trusting the company to keep it safe. With liquidity pools, users can trade directly from their wallets, removing any intermediaries from the equation. All transactions settle on-chain, yet that can make this process a lot more expensive due to network fees.

Scalability Remains A Concern

When experimenting with liquidity pools, the constraints of a blockchain come to light very quickly. More specifically, many decentralized exchanges operate on the Ethereum blockchain. As this network cannot process all of the on-chain transactions at low cost, users will often pay $20 or more to trade via liquidity pools. 

Solving this problem will pose a few challenges. Some options to explore include sidechains and layer-two solutions, yet it seems there isn’t much interest in either improvement today. Whether that situation will change remains to be seen. Many of these problems can be solved when Ethereum 2.0 launches, whenever that may be. 

Moreover, the growing focus on the Ethereum ecosystem creates a new type of scalability concern. It is nearly impossible to convert to and from Ethereum and ERC20 assets with currencies that do not fit those categories. One way to solve this problem is by creating a “bridge” between blockchains to allow cross-chain transactions. A viable concept, but one that is not getting much love today either. 

Not Peer-to-Peer Trading

One may be inclined to think that liquidity pools are a way for users to trade in a peer-to-peer manner. Users put up liquidity and allow others to trade in this market without intermediaries. Thinking along these lines is a misconception, as a liquidity pool is a “contract” for trading rather than a “peer”. 

When exploring a DEX with multiple liquidity pools, users are not trading directly with another wallet. Instead, they interface with a smart contract that depicts the current exchange rate between asset A and asset B. This form of trading doesn’t require a counterparty or a seller to buy from. 

Users who provide liquidity to the pool don’t see any of their funds disappear when trades occur, either. They expose themselves to potential price fluctuations as the ratio between both assets may shift if a big buy or sell order occurs.  If there is sufficient liquidity in the pool, such price movements are unlikely to have a big impact.

When dealing with new liquidity pools, especially regarding DeFi tokens, big buy or sell orders will make an immediate impact. If there is $10,000 in overall liquidity, and someone places a $15,000 order, the market will face significant disruption. Avoiding illiquid markets is often one’s best approach, yet it may also mean missing out on some potential profit. 

Other Use Cases For LPs

As touched upon before, liquidity pools can primarily serve a purpose for decentralized exchanges and DeFi yield farming. Both approaches are extremely valid and useful, but there are other options to explore as well. 

Issuing new tokens to a large community, for example, can be achieved in different ways. Instead of taking a blockchain snapshot of wallet balances for an airdrop, one can use liquidity mining for this purpose. Users will create a liquidity pool, and tokens are distributed algorithmically based on their pool share. 

Another use case that is gaining traction is governance participation. Some DeFi projects require a very high token voting threshold to create and pass governance proposals. By pooling funds into a liquidity pool, it becomes easier for token hodlers to meet the required thresholds. 

Some people may have noticed how the DeFi industry lacks insurance or other forms of protection. More specifically, if one engages with decentralized finance protocols and services, there is no insurance if funds are stolen or lost. That situation is slowly changing, however, as insurance protocols are coming to market. Many of these insurance-oriented services rely on liquidity pools to offer adequate protection. 

A final example of what one may achieve with liquidity pools is the minting of synthetic assets. More specifically, users need to add collateral to a pool and obtain pricing information from oracle services. The end result is a synthetic token one can peg to anything, including precious metals, stocks, and so forth. Synthesizing real-world assets on the blockchain is a legitimate use case, albeit one that has yet to gain any real traction.

The Potential Risks Of Liquidity Pools

While the number of potential use cases and profit to be gained seems limitless where liquidity pools are concerned, this concept is not without risks and possible flaws. Exploring new ideas with intermediaries provides financial freedom but also introduces more risks. Liquidity pools are no exception. 

The first issue to contend with is an impermanent loss. When providing liquidity to a DeFi protocol or DEX, users will be subject to the provided assets’ changing prices. Moreover, it is nigh impossible in a bull market to maximize one’s potential profit if funds are stuck in a liquidity pool. Read more about impermanent loss in our dedicated article on this concept. 

A second issue revolves around the technology itself. While blockchains and immutable, it still requires humans to write smart contracts. Code is law in this industry, yet the code can contain issues, flaws, backdoors, and other shortcomings. Smart contracts will always pose a risk, even if they are audited regularly. 

Finally, it will always be difficult to tell if a new DEX or DeFi platform has an “administrator key”. One can never be sure if a developer has “extra permissions” to change certain aspects of the code. If such a “key” exists, a developer can disrupt the entire project for nefarious purposes. 

Closing Thoughts

There is a lot to like about decentralized exchanges, DeFi, and liquidity pools. These concepts are intertwined regularly, yet it is crucial to understand what they mean and how they affect these ideas. A liquidity pool can introduce many use cases, ranging from loans to token issuance and insurance. However, the concept is only as strong as the code written by its developers, which will always remain a point of concern. 

That being said, the introduction of the liquidity pool concept has given rise to numerous new exchange options and decentralized finance products. It is plausible to assume this industry will see much more growth and diversity in the future thanks to liquidity pools. 

The post What Are Liquidity Pools And Why Do They Matter? appeared first on Vaultoro.

Original source: https://vaultoro.com/what-are-liquidity-pools-and-why-do-they-matter/