Some of the mechanics associated with crypto liquidity pools can get extremely difficult to understand. Starting with the fundamental principles in fairly simple and accessible words, there’s a lot more to learn about the topic. However, the silver lining is we do not require extensive technical knowledge to use a crypto liquidity pool. Understanding the fundamentals helps you to navigate and make informed decisions.
So, let’s get this party started.
Decentralized Finance (DeFi) has revolutionised the way people deal with their assets in the crypto markets since its inception. It wasn’t until the launch of DeFi that a user realised what it meant to have actual possession of his assets.
We’ve stored our crypto assets for years on one of the Centralized Exchanges (CEX) such as Binance, Coinbase, FTX, and others. They are a good option for fund liquidity, but they are a nightmare when it comes to the security dangers they expose us to. A centralised exchange holds custody of its user’s funds, which means we may lose all of our funds if the platform suffers a security breach.
DeFi protects us from this danger. But what made the DeFi ecosystem viable in the first place?
It is called Crypto Liquidity Pool.
Any DeFi platform, whether it’s a Decentralized Exchange (DEX) like Uniswap or Sushiswap, a lending platform like Maker, Compound, or AAVE, or a synthetic asset platform like Synthetix, Mirror Protocol, etc., relies on the crypto liquidity pool. The possibilities for what we can create with this ecosystem are virtually limitless.
So, first, let’s define a Crypto Liquidity Pool and how it powers a DeFi platform.
Table of Contents
What are crypto liquidity pools?
Crypto liquidity pools, in particular, are a collection of funds put in a smart contract to provide liquidity for DEX, lending and borrowing protocols, and other DeFi applications.
A liquidity pool, in essence, offers crypto traders and investors market liquidity in decentralised finance (DeFi) markets.
A crypto liquidity pool can be regarded as a decentralised alternative to an order book or matching engine that is powered by smart contracts.
How do crypto liquidity pools work?
Market liquidity is found in the order book of a specific asset or currency pair as in conventional financial markets. Buyers and sellers are matched after two parties agree on a price for the amount they wish to trade to fulfil an order.
Centralised cryptocurrency exchanges like Coinbase, Binance, and Kraken also employ order books to connect buyers and sellers for each cryptocurrency trading pair.
Serving as a market maker requires a considerable amount of capital in both regular and crypto markets (i.e. someone who makes money by providing liquidity to a market by providing bids and offers to other traders).
Anyone can become a liquidity provider in the decentralised finance (DeFi) market by depositing into a crypto liquidity pool and receiving incentives in the form of trading fees proportional to their deposit.
Liquidity providers deposit funds in smart contracts, ensuring constant liquidity for any transaction. People, rather than market makers or other users, transact against the liquidity in a smart contract.
Crypto liquidity pools employ an algorithm that determines asset pricing based on trades that occur in the pool. The algorithm ensures the pool’s liquidity by raising the price of an asset as demand rises.
What exactly are crypto liquidity pool tokens?
When liquidity providers deposit funds in a pool, they are given a liquidity provider token (LPT) representing their portion of the pool.
Liquidity provider tokens (LPTs) are used to determine the number of funds donated by LPs to a pool as well as their share of transaction fees for providing liquidity. This gives LPs ownership of their assets while they are in the pool.
LPTs can be staked, sold, or transferred to other protocols on the same blockchain because they share the same qualities as other tokens on the blockchain.
A BNB-BUSD LPT, for example, can be staked on PancakeSwap to earn the trading platform’s protocol token, CAKE.
The Role of Crypto Liquidity Pools in DeFi
Crypto liquidity pools are critical components of the decentralised finance (DeFi) ecosystem, particularly when it comes to decentralised exchanges (DEXs). Crypto liquidity pools are a technique that allows users to pool their assets in the smart contracts of a DEX to provide asset liquidity for traders to swap between currencies. Liquidity pools provide the DeFi ecosystem with much-needed liquidity, speed, and convenience.
Prior to the introduction of automated market makers (AMMs), crypto market liquidity posed a hurdle for Ethereum-based DEXs. DEXs were a new technology with a sophisticated interface at the time, and the number of buyers and sellers was limited, making it difficult to find enough people eager to trade on a regular basis. AMMs address the issue of low liquidity by forming liquidity pools and incentivizing liquidity providers to deliver assets to these pools, all without the use of third-party middlemen. The more assets and liquidity a pool has, the easier it is to trade on decentralised exchanges.
Why Are Crypto Liquidity Pools Important?
Any experienced trader, whether in traditional or crypto markets, would caution you about the dangers of trading in a market with less liquidity. Slippage will be an issue when attempting to enter — or exit — any deal, whether it’s a low-cap cryptocurrency or a penny stock. Slippage is the difference between the estimated price of a trade and the price at which it is executed. It is the most common event during moments of extreme volatility, but it can also happen when a large order is made but there isn’t enough activity at the targeted price to keep the bid-ask spread constant.
This market order price used in times of high volatility or low volume in the classic order book model is dictated by the bid-ask spread of the order book for a given trading pair. This means it’s the middle point between what sellers are willing to sell the asset for and the price at which buyers are willing to purchase it. Low liquidity, on the other hand, might result in increased slippage and, depending on the bid-ask spread for the asset at the moment, the executed trading price can much surpass the original market order price.
Liquidity pools aim to combat illiquid markets by motivating users to provide crypto liquidity in exchange for a portion of trading fees. Trading utilising liquidity pool protocols such as Bancor or Uniswap does not necessitate buyer and seller matching. This means that users may easily exchange their tokens and assets utilising liquidity offered by users and transacted using smart contracts.
How Do Crypto Liquidity Pools Work?
A functioning crypto liquidity pool must be built in such a way that crypto liquidity providers are incentivized to stake their assets in the pool. As a result, most liquidity providers earn trading fees and cryptocurrency rewards from the exchanges where they pool tokens. When a user provides liquidity to a pool, the provider is frequently compensated with liquidity provider (LP) tokens. LP tokens can be valuable assets in their own right and can be utilised in a variety of ways within the DeFi ecosystem.
LP tokens are often distributed to crypto liquidity providers in proportion to the amount of liquidity they have contributed to the pool. When a pool enables a trade, a fractional fee is divided proportionally among the LP token holders. To recover the liquidity given (together with collected fees from their half), the liquidity provider’s LP tokens must be destroyed.
Because AMM algorithms keep token prices relative to one another within any given pool, liquidity pools maintain fair market values for the tokens they hold. Different protocols’ liquidity pools may use slightly different algorithms. Uniswap liquidity pools, for example, use a constant product formula to preserve price ratios, and many DEX platforms use a similar strategy. This method ensures that a pool consistently delivers crypto market liquidity by controlling the cost and ratio of the appropriate tokens as demand grows.
Yield Farming and Crypto Liquidity Pools
To improve the trading experience, many protocols give additional incentives for users to generate liquidity by distributing more tokens for specific “incentivized” pools. Participating in these incentivized liquidity pools as a provider in order to obtain the most number of LP tokens is referred to as liquidity mining. Liquidity mining is a method used by crypto exchange liquidity providers to maximise their LP token profits on a specific market or platform.
There are numerous DeFi markets, platforms, and incentive pools where you may earn rewards for providing and mining liquidity in exchange for LP tokens. So, how does a cryptocurrency liquidity provider decide where to invest their funds? Here’s where yield farming comes in. Yield farming refers to the process of staking or locking up currency within a blockchain technology in order to produce tokenized incentives. Yield farming is the practise of staking or locking up tokens in various DeFi apps in order to produce tokenized rewards that help maximise earnings. As a result of their assets being distributed to trading pairs and incentivized pools with the highest trading fee and LP token rewards across several platforms, a crypto exchange liquidity provider might earn significant returns for a slightly higher risk. This type of liquidity investing might direct a user’s funds to the greatest earning asset pairs. Yearn. Finance platforms even automate balance risk selection and returns to move your assets to other DeFi investments that give liquidity.
The Unexpected Value of Crypto Liquidity Pools
In the early phases of DeFi, DEXs suffered from crypto market liquidity problems when attempting to model the traditional market makers. Instead of having a seller and buyer match in an order book, liquidity pools helped solve this problem by incentivizing users to provide liquidity. This provided a robust, decentralised solution to DeFi liquidity, which was critical in accelerating the sector’s growth. Liquidity pools may have been born from necessity, but their innovation brings a fresh new way to provide decentralized liquidity algorithmically through incentivized, user funded pools of asset pairs.
How to join Crypto Liquidity pools?
The technique for accessing liquidity pools varies somewhat slightly between platforms. Some are more technical and need more expertise, but others are very user-friendly and gamified to make the experience as simple as possible.
To participate in a liquidity pool, you must first register with the platform of your choice and link with a smart contract-enabled crypto wallet, such as Metamask. Following that, you must select a cryptocurrency pair and a liquidity pool into which to deposit your crypto asset.
Then you must ensure that you have enough supply of the two assets you intend to deposit. Finally, you must deposit both assets in order to receive your LP tokens.
That’s all there is to it!
What risks are involved with crypto liquidity pools?
Although liquidity pools play an extremely important role in the DeFi market, they are not without risks. These risks are discussed more below:
When the ratio of two assets kept in a liquidity pool becomes uneven due to a large price increase in one of the assets over the other, LPs may suffer temporary loss since they miss out on the gains on one of the retained assets rather than simply buying and holding them.
Smart contract bugs
If a liquidity provider withdraws their funds from the pool before the price recovers, the loss may become permanent. However, depending on the extent of the fluctuation or the duration of their deposit, liquidity providers can cover temporary losses with transaction fees.
Because a developer can decide to take control of the funds in the pool, liquidity pools with highly centralised governance allow for malicious behaviour. As a result, it is vital to make an informed decision about where to deposit funds in a pool.
Liquidity pools where governance is overly centralised give room for malicious behaviour as a developer can decide to take control of the funds in the pool. Therefore, it’s important to choose wisely where to deposit funds in a pool.
What are the benefits of crypto liquidity pools?
While taking part in liquidity pools can be somewhat challenging at first for crypto newcomers, the benefits of these new financial protocols suggest that liquidity pools are here to stay.
Let’s look at some of these benefits.
- Liquidity pools ensure there is enough liquidity for DeFi protocols, especially decentralised exchanges and lending platforms.
- Liquidity is not only available to many market makers. A pool’s liquidity can be provided by anyone.
- By deploying their liquidity providers tokens on various DeFi protocols, liquidity providers have access to many layers of earning opportunities.
- Liquidity providers can participate in the decision making of a protocol they provide liquidity for by earning governance tokens and using them to vote.
- Liquidity pools enable traders to transact in a trustless manner.
Examples of crypto liquidity pools
There are hundreds of liquidity pools in the decentralised trading space, but a handful of trading platforms have emerged as the go-to options for traders and investors looking for decentralized crypto liquidity. They include:
- Curve Finance
- Convexity Protocol
- Kyber Network
Liquidity pools exist for a wide range of assets because they can be created by users themselves. The only restriction is that the tradable tokens must be available on the chain that the liquidity pool provider operates.
For example, on Uniswap and SushiSwap, you can only trade Ethereum-based ERC20 tokens, while PancakeSwap is limited to Binance Smart Chain’s BEP20 tokens.
The most popular assets you can find in liquidity pools include ETH, BNB, and stablecoins like DAI, USDT, and USDC. Even popular “meme coins” like SafeMoon can be traded or deposited in liquidity pools.
Liquidity pools are one of the significant technologies in the present DeFi technology stack. They allow for decentralized trade, lending, and yield production, among other things. Smart contracts currently fuel practically every aspect of DeFi and will most likely continue to do so in the future. To better understand DeFi and its applications, you can begin to learn DeFi. Liquidity pools are an excellent method to make money passively using cryptocurrency. The first step is to choose a solid platform and the best pools to ensure a steady and safe income. In case of oblivion, you can always seek professional advice. However, if you want expertise in the field, you can probably check out some cryptocurrency courses. You can even opt for some blockchain certification courses as well and become an expert player in the crypto market.
Liquidity pools provide an exciting new potential earnings opportunity for crypto-savvy investors entering the fast-growing DeFi markets.