What Are Liquidity Pools in DeFi?

DeFi is an innovation in the crypto industry while the liquidity pool is a basic component of the DeFi ecosystem. DeFi users “lock” crypto assets into smart contracts to maintain the smooth operation of the DeFi protocol.

Liquidity Pools Explained

A liquidity pool refers to a cryptocurrency pool locked by smart contracts, which facilitates trading through liquidity and is widely adopted by decentralized exchanges. This concept was first proposed by Bancor in 2017, and popularized by UniSwap, one of the largest decentralized exchanges.

Before liquidity pools were created, users made transactions through order books on centralized trading platforms, where buyers and sellers placed orders according to their own will. Typically, the buyer expects to buy a cryptocurrency at the lowest price while the seller hopes to sell at the highest price. In order to match the transaction, the buyer and the seller must reach a consensus about the price.

When the buying and selling orders are insufficient to support fast transactions in the market, centralized market makers will provide liquidity to facilitate fast transactions. But in DeFi, there is no such a role as a centralized market maker. The concept of liquidity pool is hence introduced in such a context.

How do Liquidity Pools Work

Liquidity pools are executed automatically without the participation of third-party intermediaries. Simply put, two or more different cryptocurrencies are placed in a pool to form a cryptocurrency fund pool, which satisfies users’ trading needs through automatic market makers (AMMs). DeFi protocols provide rewards to incentivize users to participate as liquidity providers (LPs).

If a user sells token A to buy token B on a decentralized exchange, he relies on tokens in the A/B liquidity pools provided by other users. According to the law of supply and demand in economics, when he buys token B, the number of token B in the liquidity pool decreases while its price increases.

For example, there is an ETH/USDT liquidity pool with $10,000 worth of ETH and $10,000 worth of USDT. To buy ETH, users could simply provide USDT to the pool and get the corresponding ETH. When the trading is completed, the amount of USDT in the pool increases while ETH decreases. In order to strike a balance between the two cryptocurrencies, the price of ETH will increase. When a certain number of ETH are taken out, more USDT is needed to keep the balance in the pool.

For more details about the calculation, please refer to the Gate Learn article: What is an AMM?

How much Liquidity is in DeFi Pools?

In DeFi, liquidity is measured by total value locked (TVL). According to DappRaDar, as of November 2022, the TVL of all assets in DeFi protocols is about USD $40 billion.

DeFiLiam shows that, at the beginning of 2020, the TVL in DeFi protocols was less than USD $1 billion. Its explosive growth is indeed a good indication of the fast development of DeFi in recent years.

Use Cases for Liquidity Pools

1. Automatic Market Makers (AMM)

Decentralized exchanges like Uniswap provide liquidity pools that allow LPs to pool their cryptocurrencies into trading pairs. They rely on automatically executed smart contracts to determine asset prices and hence create a trading market.

2. Liquidity Mining

Liquidity mining is a process by which traders provide liquidity to a particular DeFi protocol and earn interest based on the proportion of the liquidity they provide to the pool. Most liquidity pools also provide LP tokens, which could be staked by LPs on other protocols to generate income in proportion to their share of the total amount of funds within the pool.

For more information about liquidity mining, please refer to:

What is Liquidity Farming?

From Market Maker to Liquidity Mining, How Important is Liquidity?

The liquidity pool is also used for voting and governance. Many protocols stipulate that a certain number of tokens are required to participate in voting and promote governance proposals. The liquidity pool is where users pool their funds together.

Important Notes

To participate in liquidity mining, users should be cautious about the risk of impermanent loss, which refers to the proportion of tokens in the liquidity pool reduced due to significant price changes. If users decide to remove their liquidity when the price falls, the loss will become real, but if the price recovers, the loss can be avoided.

Conservative investors can invest in stablecoins, which are more stable in price. Stablecoin-based liquidity pools reduce the risk of impermanent loss.

Conclusion

The liquidity pool is a treasury that locks pairs of cryptocurrencies in smart contracts, providing a center for users to participate in decentralized trading, lending, borrowing, and many other decentralized finance (DeFi) activities. It is an important component of DeFi.

In the past two years, providing liquidity in DeFi has become a popular trend. Users could participate as liquidity providers (LPs) and earn returns. Liquidity pools also face potential risks, such as impermanent loss, hacker attacks caused by contract loopholes, etc. Users should be wary of these risks when participating in income-earning activities in liquidity pools.