The Role of Liquidity Pools in DeFi: An Essential Guide

Key takeaways

• Liquidity pools are essential for liquidity in DeFi activities.
• Pooled tokens of liquidity providers (LP) constitute liquidity pools.
• In return, liquidity providers receive a share of transaction fees and LP tokens, which they can further use for passive income.
• Although they are extremely important in DeFi, they have a few associated risks.

Popular DeFi protocols like Uniswap and Balancer do not depend on any centralised authority for liquidity. Rather, they rely on pools of tokens or digital assets held in smart contracts that provide the required liquidity. During DeFi activities like lending, swapping, or trading, these pools provide the necessary tokens or funds for a successful transaction. 

Decentralised exchanges and lending protocols are particularly dependent on them in DeFi. Here’s an example to further explain this subject. Let’s suppose one wants to borrow ETH in exchange for their USDT as collateral in a DeFi lending protocol. 

Instead of interacting in a peer-to-peer mode, the borrower gets access to the ETH through a liquidity pool that conducts the transaction, and yet maintains its efficiency for future transactions. How does it do so? The next section explains it!

Popular DeFi protocols like Uniswap and Balancer do not depend on any centralised authority for liquidity. Rather, they rely on pools of tokens or digital assets held in smart contracts that provide the required liquidity. During DeFi activities like lending, swapping, or trading, these pools provide the necessary tokens or funds for a successful transaction. Decentralised exchanges and lending protocols are particularly dependent on them in DeFi.

How does it do so? The next section explains it!

How do liquidity pools work?

To create a liquidity pool, a DeFi protocol has to first convince token holders to deposit their holdings in a pool. Most DeFi protocols incentivise these depositors, known as liquidity providers, with a share of transaction fees. 

Liquidity provider (LP) tokens, which also act as evidence of their contributions to the liquidity pool, are distributed among the depositors to entitle them to a percentage of the transaction fees. Moreover, the depositors can claim to withdraw their share of the liquidity pools through their LP tokens. 

At the same time, LP token holders could also earn more by staking or yield farming their LP tokens. As a result, DeFi protocols provide multiple benefits to a liquidity provider.

Once a liquidity pool is formed, smart contracts determine token prices according to supply and demand dynamics. The algorithms within the smart contracts process trades and also ensure sufficient liquidity for future trades.

Types of liquidity pools

They can be broadly categorised into the following types:

• Constant product pools: This is one of the most common types. A constant product pool ensures that the product of the quantities of two tokens in a pool remains constant and thus keeps changing token prices after trades accordingly. Uniswap is a popular DeFi protocol which operates constant product pools.
• Stablecoin pools: These mainly focus on stablecoins. They usually use specialised algorithms to conduct smooth stablecoin trades with minimum slippage and fees. Protocols like Curve Finance are known for their stablecoin pools.
• Lending pools: As indicated by its name, these pools are used by lending protocols like Aave to enable their borrowers to access loans by depositing their own crypto assets as collateral.
• Smart pools: Unlike constant product pools, smart pools allow their creators to set customised settings. The creators get more control and flexibility over the pool’s composition with custom weights or fees. For example, Balancer is a DeFi protocol in this category.
• Algorithmic pools: These pools, operated by those like Shell protocol, depend entirely on algorithms in smart contracts to adjust pricing or settings.  

The role of liquidity pools in DeFi

As the primary source of liquidity in DeFi protocols, liquidity pools perform the most important task in DeFi. An illiquid market can lead to multiple issues, ranging from slower transactions or high volatility, slippages to even unsuccessful trades. 

But, what are slippages? It is a common term in trading, and refers to when a trade does not get executed at an expected price. It leads to a price difference between the actual trade and the requested trade, which is called slippage. It is very common in highly volatile markets, and has also been experienced by crypto traders.

Thus, liquidity pools are very important for trades to occur smoothly without slippages.

They help avoid these problems and thus form the backbone of decentralised finance. Along with other factors like smart contracts, they ensure seamless DeFi activities.

They lead to innovation and growth in the overall DeFi sector. For example, in PancakeSwap, one can provide liquidity by staking CAKE and earning PEPE. Liquidity pools also serve as a means of income for liquidity providers, which is another one of their benefits.

Risks of liquidity pools

Here are some risks of liquidity pools:

• Impermanent loss: The volatility in crypto token prices could lead to an impermanent loss, which is one of the most common risks. Suppose one deposits tokens in a liquidity provider, and one or both of the tokens experience high volatility immediately after. In that case, the liquidity provider could have likely seen better values of their holdings if they had just held on to their tokens instead of depositing them in a liquidity pool. 

  This mainly happens because many staking pools require a locking period. During this period, if a token experiences high volatility to the downside, the pool could block the selling of that particular token.

• Access risks: Developers in liquidity pools could have exclusive access to the smart contract codes of the pools. In that case, there is a possibility of malicious activities, like changing regulations of the pool or stealing funds.
• Smart contract risks: These are risks associated with smart contracts in liquidity pools like rug pulls or flash loans.

Liquidity pools: the bedrock of DeFi

The very goal of DeFi, to enable financial services without any intermediaries, has been unlocked with the concept of liquidity pools. It has led to the emergence of inclusive financial services, independent of the control of centralised institutions. 

They have shifted the reins of governance to the hands of all stakeholders in a DeFi protocol. Apart from a few associated risks that are to be noted by liquidity providers, they have the potential to take DeFi to greater heights of adoption.

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FAQs

• How do I become a liquidity provider (LP) in a DeFi pool?

  You can become a liquidity provider by depositing/staking your tokens in a liquidity pool of any DeFi protocol.

• What are the benefits of being a liquidity provider?

  As a liquidity provider (LP), you get a share of transaction fees from the liquidity pools and also LP tokens from which you can earn a passive income through staking or yield farming. In some protocols, LP tokens are also used for platform governance.

• What is impermanent loss, and how can I avoid it?

  Let us explain this concept with an example. Suppose you invest your ETH and MATIC in a liquidity pool, and the pool maintains your deposits in a 50:50 ratio. If the price of ETH suddenly rises, and the price of MATIC doesn’t, then the value of your deposits will still rise, but not according to ETH’s real value, as the liquidity pool will maintain the 50:50 ratio. In this case, you could have seen more potential gains had you not deposited the tokens and just held on to them. This is called impermanent loss.

  If the inverse happens, and ETH falls while MATIC doesn’t, you will lose more than the real losses of ETH. Impermanent loss can also happen if the prices of both tokens fall or both move in opposite directions.You can avoid impermanent losses by depositing less volatile coins or sticking to only stablecoin pairs. Liquidity pools whose ratios are customisable could also help.

• What are popular liquidity pool providers?

  Balancer, SushiSwap, Uniswap, and Curve Finance are some popular liquidity pool providers.