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Everything You Need to Know About Liquidity Pools

Liquidity pools are one of the foundational technologies behind the current Decentralised Finance (DeFi) ecosystem. Essentially, they are large funds of money used to facilitate token trading on decentralised exchanges (DEX). These pools of cryptocurrency are crowd sourced and provide the liquidity required for digital assets to be traded for each other using automated market makers. Liquidity pools are essential to yield farming, synthetic assets, blockchain gaming, on-chain insurance, burrow-lend protocols and automated market makers to name a few. Overall, liquidity pools and their providers are the reason we have such a flourishing decentralised finance ecosystem.  

We’re going to take a look at liquidity pools and uncover exactly what they do within DeFi. 

What’s a Liquidity Pool? 

In simple terms, a liquidity pool functions as a vault where users deposit different crypto assets to make DEX markets more liquid. When they deposit into a liquidity pool, users create trading pairs, which form a market. Then users can trade different cryptocurrencies for each other by using these trading pairs. 

The idea of a ‘vault’ allows for the whole process to be handled automatically by code. This ensures that liquidity pools are permission less. This allows for greater trust between parties as the entire process from start to finish is handled automatically, and everything is secure. Additionally, anyone can contribute to these pools, so they have the added benefit of being accessible too. 

How do Liquidity Pools Work?

Centralised exchanges tend to rely solely on books and market markets to boost liquidity and facilitate trades. This traditional model just doesn’t fork for DeFi as the trades are happening quickly on-chain and could incur high fees.

Instead of this, in liquidity pools, automated market makers (AMM) are used to facilitate on-chain trading and manage prices without the need for order books. AMM’s use complicated algorithms and smart contracts to constantly rebalance prices according to supply and demand and this allows traders to obtain positions using illiquid pairs that would be difficult to execute otherwise. 

This occurs because when a trade happens using an AMM, you are actively trading against the liquidity in the pool, making virtually any token pair possible (such as USDC-ETH). This also means that as a buyer you don’t need to match up with the seller, you only need there to be enough liquidity within the pool itself. 

Incentives for Liquidity Pools

To encourage users to deposit and lock in their cryptocurrency into liquidity pools, protocols offer incentives, often in the form of liquidity pool tokens. These tokens represent the user's stake in the pool and have a value of their own. This process Is known as liquidity mining or yield farming. During this process, users’ funds are usually locked up for a set period of time, with the reward calculated to be the annual percentage yield (APY) of their contribution overall. 

Many blockchains have their own token standards, but all follow a standard model. For example, Ethereum allows most deposits to be made using an ERC-20 token, with the yield rewards issued as the same, and then rewards for pledging assets into liquidity pools are funded by the protocol fees or are newly minted. 

What The Future Holds

The gap between blockchains is being bridged by liquidity pools. Known as cross-chain bridges, there is an emerging technology that allows different blockchains to interoperate as securely as possible. These bridges can facilitate the interaction between disparate networks’ token standards and smart contract codes, allowing for trading between them. 

As well as the growing DeFi insurance sector, liquidity pools are also being put forward as a way to boost voting power with governance tokens. With like-minded people pooling their governance tokens, users can effect change in different protocols if enough support is provided.

In addition, there’s an emerging DeFi sector known as insurance against smart contract risk, the implementation of these insurances is powered by liquidity pools, and is expected to grow in the future.

Risks Involved

Risks related to liquidity pools are low, but there are some to be aware of. 

The first is impermanent loss. This is a loss in dollar value that occurs when the price of your locked-in assets changes in relation to when you added them to the pool. This loss can sometimes be small, or catastrophic, so make sure to be aware of how to reduce this risk.

The next issue that comes up is smart contract bugs, these occur when you deposit funds into a pool. This means that there are no middlemen holding your funds, so these smart contracts used can suffer from bugs. These bugs can be human error, tech errors or exploits such as a flash loan that can lose your funds forever. 

We would also advise that you be wary of projects where developers have permission to change the rules governing the pool itself. Some developers have an admin key or access to the smart contract code, and this can enable them to potentially undertake malicious undertakings like taking control of the funds in the pool.

Although these risks are rare, awareness can also reduce risk exponentially, so make sure to keep an eye out for these factors. 

The Verdict

In the current DeFi technology stack, liquidity pools are emerging as a core technology. They enable decentralised trading, yield generation, lending and much more. We have found that liquidity pools are the perfect solution to the current illiquidity issues DeFi faces, but are complicated to understand and undertake solo. 

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