Liquidity pools are one of the foundational technologies powering the modern DeFi ecosystem. They form an essential part of automated market makers (AMMs), lending protocols, yield farming, synthetic assets, on-chain insurance, and blockchain-based gaming—the list goes on.
At their core, liquidity pools are remarkably simple. They are essentially funds pooled together into a large digital reservoir. But what can you do with this pool in a permissionless environment where anyone can contribute liquidity? Let’s explore how DeFi has iterated on the concept of liquidity pools.
Introduction
Decentralized Finance (DeFi) has sparked an explosion of on-chain activity. Decentralized exchange (DEX) trading volumes now compete significantly with those of centralized exchanges. The total value locked (TVL) in DeFi protocols continues to reflect billions of dollars, demonstrating rapid ecosystem expansion and new financial products.
What makes all this growth possible? One of the fundamental technologies behind these innovations is the liquidity pool.
What Is a Liquidity Pool?
A liquidity pool is a collection of funds locked in a smart contract. These pools are used to facilitate decentralized trading, lending, and many other functions we’ll explore later.
Liquidity pools serve as the backbone of many decentralized exchanges like Uniswap. Users known as liquidity providers (LPs) deposit an equivalent value of two tokens into a pool to create a market. In return, they earn trading fees from transactions that occur in that pool, proportional to their share of the total liquidity.
Since anyone can become a liquidity provider, AMMs have democratized market-making.
Bancor was one of the first protocols to use liquidity pools, but the concept gained wider attention with the rise of Uniswap. Other popular Ethereum-based exchanges using liquidity pools include SushiSwap, Curve, and Balancer. These platforms’ pools typically contain ERC-20 tokens. On Binance Smart Chain (BSC), similar equivalents include PancakeSwap, BakerySwap, and BurgerSwap, whose pools contain BEP-20 tokens.
Liquidity Pools vs. Order Books
To understand how liquidity pools differ, let’s examine the cornerstone of electronic trading—the order book. Simply put, an order book is a collection of currently open orders for a specific market.
The system that matches these orders is called a matching engine. Together with the matching engine, the order book forms the core of every centralized exchange (CEX). This model efficiently facilitates trades and enables the creation of complex financial markets.
DeFi trading, however, involves executing trades on-chain without a centralized third party holding funds. This presents challenges for order books. Each interaction with an order book requires gas fees, making trading significantly more expensive.
It also makes the role of market makers—traders who provide liquidity for tradeable pairs—very costly. Moreover, most blockchains cannot handle the performance required to trade trillions of dollars daily.
This means that on a blockchain like Ethereum, an on-chain order book exchange is practically impossible. While sidechains or Layer 2 solutions may offer future alternatives, the current network cannot provide the necessary performance.
It’s worth noting that some DEXs do function well with on-chain order books. Binance DEX, built on Binance Chain, is specifically designed for fast, low-cost trading. Another example is Project Serum, built on the Solana blockchain.
However, since many crypto assets reside on Ethereum, trading them on other networks requires cross-chain bridges.
How Do Liquidity Pools Work?
Automated market makers (AMMs) have been a game-changer. This significant innovation enables on-chain trading without an order book. Since no direct counterparty is needed to execute trades, users can enter and exit positions in token pairs that would likely be illiquid on order book-based exchanges.
You can think of an order book exchange as a peer-to-peer platform where buyers and sellers connect through the order book. For example, trading on Binance DEX is peer-to-peer since trades occur directly between users’ wallets.
Trading using an AMM is different. You can imagine AMM trading as peer-to-contract.
As mentioned, a liquidity pool is a collection of funds deposited into a smart contract by liquidity providers. When you trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you trade against the liquidity in the pool. For a buyer to purchase, there doesn’t need to be a seller at that moment—only sufficient liquidity in the pool.
When you buy tokens on Uniswap, there isn’t a traditional seller on the other side. Instead, your transaction is managed by the algorithm governing the pool. The price is also determined by this algorithm based on pool activity.
Of course, liquidity must come from somewhere, and anyone can be a liquidity provider, so they could be seen as your counterparty in some sense. But it’s not the same as the order book model, since you’re interacting with the smart contract governing the pool.
What Are Liquidity Pools Used For?
So far, we’ve mainly discussed AMMs, the most popular use case for liquidity pools. However, as mentioned, liquidity pooling is a simple concept that can be applied in various ways.
One such application is yield farming or liquidity mining. Liquidity pools form the basis of automated yield-generation platforms like Yearn, where users aggregate their funds into pools that generate returns.
Distributing new tokens to the right users is a significant challenge for crypto projects. Liquidity mining has been one of the most successful approaches. Essentially, tokens are algorithmically distributed to users who deposit their tokens into a liquidity pool. Newly minted tokens are then distributed proportionally to each user’s share in the pool.
Note that these can even be tokens from other liquidity pools, called pool tokens. For example, if you provide liquidity to Uniswap or lend funds to Compound, you receive tokens representing your share in the pool. You might deposit those tokens into another pool to earn additional returns. These chains can become quite complex as protocols integrate pool tokens from other protocols into their products.
We can also consider governance as a use case. In some instances, a very high threshold of token votes is required to formally submit a governance proposal. By pooling funds, participants can unite behind a common cause they deem important for the protocol.
Another emerging DeFi sector is smart contract risk insurance. Many implementations also operate using liquidity pools.
Another innovative use of pooled liquidity is tranching—a concept borrowed from traditional finance that involves dividing financial products based on their risk and return profiles. These products allow LPs to select customized risk-return profiles.
The minting of synthetic assets on the blockchain also relies on liquidity pools. Users add collateral to a liquidity pool, connect it to a reliable oracle, and obtain a synthetic token pegged to any desired asset. In practice, it’s more complicated, but the basic idea remains simple.
What else? There are likely many more uses for liquidity pools yet to be discovered, depending on the ingenuity of DeFi developers.
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Risks of Liquidity Pools
If you provide liquidity to an AMM, you should understand a concept called impermanent loss. In short, it’s a loss of dollar value compared to simply holding (HODLing) when you provide liquidity to an AMM.
If you’re providing liquidity to an AMM, you’re likely exposed to impermanent loss. Sometimes it’s minimal; sometimes it’s significant. Make sure to research this thoroughly before depositing funds into a two-sided liquidity pool.
Another consideration is smart contract risk. When you deposit funds into a liquidity pool, they remain in the pool. So, while there are no intermediaries holding your funds, the contract itself acts as the custodian. If there’s a bug or an exploit via a flash loan, for example, your funds could be lost forever.
Additionally, be cautious with projects where developers have permission to change the rules governing the pool. Sometimes developers may have an admin key or other privileged access within the smart contract code. This could allow them to perform potentially malicious actions, such as taking control of the pool’s funds. Always research projects thoroughly to avoid rug pulls and exit scams.
Frequently Asked Questions
What is the main purpose of a liquidity pool?
Liquidity pools enable decentralized trading by providing readily available assets for swaps. They eliminate the need for traditional order books and allow users to trade directly against pooled funds, ensuring market stability and continuous liquidity.
How do liquidity providers earn rewards?
Liquidity providers earn a share of the trading fees generated by the pool proportional to their contributed liquidity. Some protocols also offer additional incentives through liquidity mining programs that distribute native tokens to participants.
What is impermanent loss?
Impermanent loss occurs when the value of deposited assets in a liquidity pool changes compared to simply holding them. This usually happens due to price volatility between the paired assets and can result in a temporary or permanent loss depending on market movements.
Are liquidity pools safe to use?
While liquidity pools are fundamental to DeFi, they carry risks including smart contract vulnerabilities, impermanent loss, and potential protocol failures. Users should only invest in well-audited protocols and understand the risks before providing liquidity.
Can I withdraw my funds from a liquidity pool at any time?
Yes, in most cases you can withdraw your funds at any time unless the protocol specifies a locking period. However, withdrawing during periods of high volatility may increase exposure to impermanent loss.
Do all DeFi platforms use liquidity pools?
Not all, but many DeFi platforms rely on liquidity pools for core functions including decentralized exchanges, lending protocols, yield farming, and synthetic asset issuance. They have become a standard infrastructure component in the ecosystem.
Conclusion
Liquidity pools are a central technology behind the current DeFi technology stack. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power nearly every part of DeFi and will likely continue to do so as the ecosystem evolves.