Liquidity is an important term that we have all heard of in both cryptocurrency and traditional finance markets. It allows users the ability to convert cash quickly and efficiently while avoiding drastic price fluctuations. The more liquid an asset is, the easier and faster it is to convert the asset into cash.
Liquidity pools play a huge role in ensuring the smooth running of decentralized finance (DeFi) systems. Unlike traditional finance systems where the buyers and sellers of an asset provides the liquidity, DeFi systems rely on liquidity pools to finance its functions such as lending, borrowing or swapping of tokens.
What is a liquidity pool?
A liquidity pool is a pool of cryptocurrency funds that are locked in a smart contract on the blockchain. The smart contact is a self-executing program that automatically executes an action when certain conditions are met, and this allows liquidity pools to facilitate trading of different cryptocurrency tokens in a decentralized exchange (DEX) automatically without the need for intermediaries or traditional order books.
In a liquidity pool, traders can deposit tokens into the pool to become liquidity providers (LPs) and they will receive tokens in exchange. These tokens represent a share of the liquidity pool that the trader had contributed and can later be used to exchange for rewards from the pool. This helps to incentivize traders to become liquidity providers and ensure that the liquidity pool does not dry up.
How do liquidity pools work?
The core mechanism of a liquidity pool are the automated market makers (AMMs). An AMM is an algorithm or a piece of code that allows tokens to be traded automatically, while setting the price of the tokens depending on the demand and supply of the tokens in the pool.
For example, when a trader buys token A using token B, they will deposit token B into the A/B liquidity pool and receive token A in exchange. There will be a lesser amount of token A in the pool and the AMM algorithm will automatically adjust the prices of the tokens based on the new supply and demand, which causes the price of token A to go up.
The more tokens there are in the liquidity pool, the lower the price of the token, and vice versa.
Some of the more popular DeFi exchanges that uses liquidity pools are SushiSwap and Uniswap.
Why use liquidity pools?
1. Lower slippage
In both traditional and crypto markets, traders often encounter the issue of difference between the expected price and the executed price of the tokens being traded. This is also known as slippage.
High slippages are caused by low liquidity as any change in supply of tokens in a pool can result in a large imbalance due to the low amount of tokens being available in the pool.
Liquidity pools aim to eliminate this issue by incentivizing users to become liquidity providers and receive LP tokens for a share of the trading fees. These tokens can be used to earn other rewards such as yield farming.
Read more: https://blog.cyberk.io/2023/02/17/yield-farming-in-defi-alpaca-finance/
Compared to traditional order book exchanges, liquidity pools also provide a much lower slippage rate, which allows users to trade large volumes of tokens easier and faster.
2. Lower trading fees
Liquidity pools allow traders to trade with lower fees compared to traditional exchanges as they remove any intermediaries and make use of the AMM algorithm to automate every transaction. This helps to speed up the transaction speeds and allow traders to trade with more efficiency.
3. Decentralization and transparency
The use of publicly viewable smart contracts also provide greater transparency for traders and they are able to have full control of their assets and funds.
Downside of liquidity pools
Being in a highly competitive environment, traders often tend to chase extremely high yields and then leaving with the returns. This can make liquidity pools unsustainable if traders choose to sell off the LP tokens they receive immediately.
The use of smart contracts can also be susceptible to hacks or bugs. This can be a huge problem as it can drive away potential investors and traders, causing the liquidity pool to dry up. To prevent such cases, projects have to employ security audits before deploying their smart contract for the liquidity pool.
Liquidity pools are also at risk of impermanent loss, which occurs when the price of your deposited tokens changes while locked up in the liquidity pool and falls lower than the price when they are first deposited. This means that you would have suffered an unrealized loss and compared to if you had held your tokens in your own wallet.
Conclusion
In summary, liquidity pools are an essential component of the DeFi ecosystem. It allows a more efficient and cost-effective way for traders to trade their cryptocurrencies, while also offering greater transparency and control over their own assets. The greater challenge of liquidity lies in solving how liquidity pools can provide greater incentives to keep their investors and liquidity providers.
