Liquidity pools are the foundational technology behind the DeFi ecosystem, also known as the catch-all term for different financial services and products in the blockchain. This means that liquidity pools are the funds that run the automated market makers (AMM), yield farming, blockchain gaming, on-chain insurance, borrow-lend protocols, synthetic assets and more.
At its core, liquidity pools have a simple purpose and that is to support the ecosystem of DeFi using funds thrown together in a huge digital pile by different investors. These pools make it possible for DeFi networks to expand and offer new products to create a better crypto ecosystem. Get to know more about liquidity pools when you read this article.
What is a liquidity pool?
A liquidity pool is a digital pile of funds locked in a smart contract enables the functions of the DeFi services such as lending, trading and more. For this reason, it is seen as the backbone of decentralised exchanges.
Anyone participating in a liquidity pool is called a liquidity provider (LP). These investors can add an equal value of two tokens in a pool to create a market in the DeFi ecosystem. In return for the funds they provided, investors will earn trading fees from the exchanges that happen within their pool. The amount that LPs would earn will be proportional to the amount they have invested.
Since liquidity pools are a permissionless environment and anyone can become a liquidity provider, AMMs within the DeFi have made the market more accessible thereby making it easier for people to earn more conveniently in the crypto ecosystem.
How do liquidity pools work?
The basic rationale behind liquidity pools is quite simple. Funds are needed if you want to see any economic activity within the DeFi. These funds need to be somewhat supplied and that is where the liquidity pool comes in.
All trades in DeFi are executed on-chain, meaning there is no central party holding the funds. Instead, what you have is access to liquidity pools where you can either sell, buy or even take part in funding tokens.
Think of it this way, when you want to sell token A to buy token B on a decentralised exchange, you need to rely on an A/B liquidity pool provided by the LP. Part of the fees that you pay on the trades made inside the pool would go to the LP.
Token value in liquidity pools
Liquidity pools are an ecosystem of their own. The values of the token depend on the behaviour of everyone participating in the trading and funding within the pool. For example, if traders continue to purchase token B and pay using token A, the price of token B would increase while the price of token A would decrease just like in a simple supply and demand dynamic.
Peer to contract model in liquidity pools
Liquidity pools follow the peer to contract model instead of the more popular peer to peer framework. In this model, you don’t exactly interact with the seller or buyer; what you do is that you interact with the contract that governs the pool since all funds in liquidity pools are deposited on smart contracts by the providers.
All of the trades are executed against the liquidity inside the pools, which means that a seller isn’t required for a buyer to buy a token, the pool only needs to have sufficient funds to complete your transaction.
What are liquidity pools used for?
AMMs are one of the most popular use for liquidity pools and that is exactly what we have discussed thus far in the article. In essence, they markets where users can buy and sell tokens using the funds that you deposited in the smart contract. However, there are some other uses for liquidity pools in the decentralised exchange network. Discover where you can use liquidity pools below:
Yield farming uses decentralised finance to maximise your return on investment. In this use case, you earn yield by investing tokens in a decentralised application or dApp. These dApps can either be DEX, crypto wallets, or decentralised social media.
In yield farming, you can use DEX to borrow, lend or stake your coins to speculate on crypto price swings and earn huge interests. Yield farming in DeFi is often facilitated by smart contracts or codes that automate the financial agreement between participating parties.
Mint synthetic assets
Liquidity pools can be used to mint synthetic assets for public blockchains. These assets differ from your regular traditional currencies since it is a derivative, which means that it gets their value from an underlying index or commodity.
Synthetic assets function as the asset you have used as collateral for its existence. To mint your own synthetic asset, you need to offer a collateral asset in a liquidity pool and connect this asset to a trusted oracle.
How to choose a liquidity pool
If you are looking for a profitable liquidity pool, then you need to keep your eyes open for these qualities of a good liquidity pool below:
As a liquidity provider, you would only earn your share if there are trades happening within the pool. For that reason, you need to make sure that the liquidity pool you are investing in has a huge daily trading volume.
The next thing that you need to keep in mind is the pool liquidity or reserves. A pool that has a low reserve is prone to price slippage, which means that the price ratio of the tokens would be subjected to wild swings.
Price divergence of the tokens
When choosing a liquidity pool, you need to make sure that there is as little price divergence between the tokens as possible. This is due to the fact that if a price of the tokens in the pool move opposite to each other, your investment would suffer from an impermanent loss. Having a high price divergence could lead to experiencing more losses once you exit the liquidity.