Today decentralized finance activities such as lending, borrowing, or exchanging tokens rely on smart contracts. These smart contracts allow users to freeze crypto into liquidity pools that are available for other people to use.
So, liquidity pools are a unique innovation of the crypto industry and have no direct equivalent in traditional finance. They serve as a vital resource for the core activities of a decentralized finance protocol and also attract investors looking for high-return opportunities. But what exactly are liquidity pools and why are they so important to the DeFi ecosystem? In this material, we will explore the concept of liquidity pools, how they work, and why they play a critical role in the DeFi field.
Why are liquidity pools important in DeFi?
Now DeFi provides financial services typically limited to centralized exchanges, such as trading, lending, and more, but in a completely transparent and safe way. To achieve this, DeFi applications rely heavily on the technology of liquidity pools. In DeFi, this is a critical factor as it facilitates the smooth functioning of the exchange and allows traders to enter and exit positions with minimal slippage.
DeFi liquidity refers to the availability of funds on a decentralized exchange that can be easily bought, or sold without significantly affecting the market cost. DeFi liquidity to a pool is typically supplied by liquidity providers who invest their digital currency in a pool, which is then used to facilitate operations on the exchange. In return, liquidity providers receive a share of the trading fees. The more liquidity available on an exchange, the easier it is to execute trades.
Essentially, a liquidity pool is a set of tokens frozen into a smart contract. Also, liquidity pools are smart contracts implemented in the network. When users invest their assets into a liquidity pool, they interact with the smart contract to get LP tokens.
How do liquidity pools work?
So, liquidity pools are one of the fundamental technologies in the DeFi environment. They are used by AMMs, liquidity mining, farming, and many other areas. In other words, any practice that requires immediate access to funding without counterparty involvement. Let’s take a closer look at how the liquidity pool works:
- The pool consists of two types of tokens, which allows for the creation of a new market for the exchange of crypto. The coins can be of any type, but most often there is an ETH or BTC in the pair, which is countered by another digital currency.
- When creating a new pool, the first liquidity provider determines the starting exchange rate of tokens within the created system. Each of the participants must deposit an equal amount of tokens of both types.
- If there is a large price difference within the pool compared to global trends, arbitrage is possible. Providers then risk losing all of their invested capital. Maintaining the balance between coins is one of the main conditions of the system.
- Each user will receive LP tokens based on the amount of funding provided, which will be credited to the user after the transfer of currency. All investors participate in coin giveaways, which are a commission of the decentralized exchange.
- When a user wishes to withdraw funds from the pool, he/she will need to burn the existing LP tokens issued during the transfer of assets.
Above we mentioned the term AMM or Automatic Market Maker. This is a mechanism that allows each exchange of crypto passing through the pool to change the cost according to the work of a special algorithm. The AMM system in each pool is different as the market maker is modified and improved. AMMs also allow traders to make deals not with each other, but directly with a smart contract.
Having a large number of assets reduces the impact of operations on the exchange rate. This is the ultimate goal of market participants and liquidity providers. Today liquidity pools make it possible to eliminate the use of order books and to distribute all the profits from the operation of a marketplace among the depositors. They have already gained a foothold in the world of trading and decentralized exchanges, providing new opportunities for the development of markets.
In addition, because liquidity pools are self-contained, decentralized exchanges don’t require special books, which helps reduce the risk of front-running and other types of market manipulation.
Why is low liquidity a challenge?
Now low liquidity is a challenge because it can lead to some problems in the operation of a pool. For traders, it can result in high slippage, making it difficult to execute trades at the desired price. This can lead to higher commissions and reduced profitability.
Are DeFi liquidity pools safe?
This is one of the main questions that interest those who want to provide liquidity to the pool. Such pools in DeFi are generally considered safe, but there are some risks associated with participating for the purpose to provide liquidity.
One of the main problems is impermanent loss. This is a phenomenon that can occur in pools where users who provide liquidity may experience a temporary loss of value due to changes in the relative prices of the assets. This factor is the main obstacle to decentralized exchanges becoming mainstream. If the value of a coin increases by 500%, the volatility loss will increase to 25.5%. To avoid this situation, you can invest in low-volatility pairs tied to stablecoins.
Decentralized exchange pools consist of two coins, with users adding assets of equal value. If a site achieves an ideal balance at a 50/50 ratio, then proportional investments will maintain an ideal trading environment. DEXes are governed by the laws of supply and demand, which also leads to some problems.
In such a system, the price of assets changes depending on the actions of market participants, while external sources have no influence. If the movements of the charts are too abrupt, third parties are brought in to make adjustments and arbitrage is possible.
Providers can also spread their crypto across multiple exchanges to reduce exposure to any one asset or exchange platform. It is also important to consider the risks and rewards of participating in a particular platform and to be aware of fees.
Who’s using DeFi liquidity pools?
These pools are used by a variety of participants in the DeFi field, including traders, liquidity providers, and developers. For example, people can exchange coins without having to rely on centralized exchanges (CEX). Users can quickly buy or sell digital assets at a fair market price without worrying about order book depth. Developers can also create new ways for users to earn returns on their crypto. Overall, this technology has become an important component of the DeFi area.