What are liquidity pools? The ultimate guide to DeFi mechanics

Learn how permissioned vs permissionless blockchains differ from each other, and find out which one suits the needs of various industries. Sign up for free online courses covering the most important core topics in the crypto universe and earn your on-chain certificate – demonstrating your new knowledge of major Web3 topics. As of January 2022, approximately 1.7 billion adults worldwide were estimated to be https://www.xcritical.com/ unbanked, according to data from the World Bank’s Global Findex database. In other words, close to one-quarter of the world’s population does not have an account with a financial institution.

Yield Farming and Liquidity Pools

Unlike traditional cryptocurrency exchanges that use order books, the price in a DEX is typically set by an Automated Market Maker (AMM). When a trade is executed, the AMM uses a mathematical formula to calculate how much of each asset in the pool crypto liquidity meaning needs to be swapped in order to fulfill the trade. This incentive structure has given rise to a crypto investment strategy known as yield farming, where users move assets across different protocols to benefit from yields before they dry up. SushiSwap began as a fork of Uniswap but has since developed its own identity and unique features. One of its distinguishing characteristics is the additional rewards offered to liquidity providers through its native governance token, SUSHI.

Permissioned vs. Permissionless Blockchain: A comprehensive guide

• For that reason, secure exchanges are the ones that utilize different tools at once so that they won’t be affected by sudden increases or decreases in trading volume.
• Liquidity pools can reduce slippage, which is the difference between the expected price of a trade and the price at which it is executed.
• Vineet drives the growth strategy and its execution through product innovation, product marketing and brand building.
• Unlike traditional cryptocurrency exchanges that use order books, the price in a DEX is typically set by an Automated Market Maker (AMM).

Impermanent loss occurs when the price of one or both tokens in a liquidity pool changes significantly. This can lead to a situation where the value of the tokens in the pool is lower than if the user had simply held the tokens in their wallet. To understand how liquidity pools are different, let’s look at the fundamental building block of electronic trading – the order book. Simply put, the order book is a collection of the currently open orders for a given market.

What is Liquidity in Crypto Markets?

A liquidity pool is basically funds thrown together in a big digital pile. But what can you do with this pile in a permissionless environment, where anyone can add liquidity to it? The availability of buyers and sellers makes it higher for any individual trade to affect the change in the price of a cryptocurrency. Be careful of projects where the developers can change the rules of the pool.

Liquidity Pools Are Essential To the Operations Of DeFi Technology

No matter which protocol you take as an example, they exist there, providing a possibility to conduct transactions for the crypto market participants. As discussed, liquidity providers get LP tokens when they provide liquidity to the pool. With superfluid staking, those liquidity pool tokens can then be staked in order to earn more rewards. They use automated market makers (AMMs), which are essentially mathematical functions that dictate prices in accordance with supply and demand.

What are liquidity pools? An intro to providing liquidity in DeFi

Liquidity providers are crypto exchange users who use their tokens to provide liquidity for the pool. In return, the exchange provides them with tokens representing a portion of the pool. They earn a fraction of every transaction fee paid when the investors buy and sell crypto. When a new pool is created, the first liquidity provider is the one that sets the initial price of the assets in the pool. The liquidity provider is incentivised to supply an equal value of both tokens to the pool.

Fixed Deposits vs. Mutual Funds- Which Investment is Right for You?

These platforms cater to more specific use cases, attracting different types of liquidity providers and traders. Liquidity pools rely on liquidity providers (LPs), who deposit pairs of tokens into the pool. In return for supplying liquidity, LPs earn a share of the trading fees generated by the platform. For example, on Uniswap, LPs contribute equal values of two tokens (like ETH and USDT) into a pool. When users trade on the platform, a small fee is collected, and a portion of this fee is distributed to the LPs as a reward for their contribution.

Fortunately, most decentralized exchange platforms will allow you to set slippage limits as a percentage of the trade. But keep in mind that a low slippage limit may delay the transaction or even cancel it. If hackers are able to find a bug in the smart contract, they may be able to drain the liquidity pool of all its assets. The amount a liquidity provider will earn when they provide liquidity to a pool can vary based on a number of different factors. The LP tokens can be redeemed for the underlying assets at any time, and the smart contract will automatically issue the appropriate number of underlying tokens to the user. DeFi, or decentralized finance—a catch-all term for financial services and products on the blockchain—is no different.

Upon providing a pool with liquidity, the provider usually receives a reward in the form of liquidity provider (LP) tokens. These tokens have their own value and can be used for various functions throughout the DeFi ecosystem. To retrieve the funds they deposited into the pool (plus the fees they’ve earned), providers must destroy their LP tokens. If you provide liquidity to an AMM, you’ll need to be aware of a concept called impermanent loss.

Another, even more cutting-edge use of liquidity pools is for tranching. It’s a concept borrowed from traditional finance that involves dividing up financial products based on their risks and returns. As you’d expect, these products allow LPs to select customized risk and return profiles. Usually, a crypto liquidity provider receives LP tokens in proportion to the amount of liquidity they have supplied to the pool.

Beware of volatile tokens, pump and dump schemes, rug pulls, and APY nosediving. Scammers will hype a project and create immediate interest, then once they access the liquidity, they will prevent providers from withdrawing their funds by blocking fraudulent token sales. Rug pull scheme is hard to detect, and usually very quick to execute, leaving its victims unable to react. Also, it enables traders to swap any token as long as the said token is contained in any of the liquidity pools.

However, it’s essential to understand that providing liquidity isn’t without risks, which we’ll cover later. As we’ve mentioned, a liquidity pool is a bunch of funds deposited into a smart contract by liquidity providers. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool.

For traders, the benefits of increased liquidity include reduced slippage and faster transactions. In illiquid markets, trades can be subject to slippage, where an order can’t be filled at a single price in its entirety. This can result in buys being executed at higher prices and sells being executed at lower prices. More liquidity also means faster transactions, as there are more funds to go around.

Other projects iterated on this concept and came up with a few interesting ideas. But what if there is no one willing to place their orders at a fair price level? If one investor is holding the vast majority of the LP they can manipulate prices and incur losses. Speaking of losses, there is a specific category of risk connected with farms – impermanent loss.

Below are a few reasons why liquidity pools play such an important role. When a user provides liquidity, a smart contract issues liquidity pool (LP) tokens. These tokens represent the provider’s share of assets in the liquidity pool. Liquidity pools are an innovation of the crypto industry, with no immediate equivalent in traditional finance.

For example, TraderJoeXYZ will offer 5% APY for providing liquidity but offer native JOE tokens for those who stake their LP tokens. The truth is, as long as you give the tokens as rewards, you will have liquidity providers with you. When the financial incentive (in the form of tokens) is gone, the liquidity providers are also gone. For example, if there is $1M in tokens in the liquidity pool, and the user conducts a sell transaction for $100k, the price will drop by around 10%.

Learn more about Consensus 2024, CoinDesk’s longest-running and most influential event that brings together all sides of crypto, blockchain and Web3. Reducing the size of the assets that are transferred minimizes the impact they have on the market. Smart contracts manage the assets added to a pool; there is no central authority or custodian for these assets.