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General Knowledge Crypto Basics

Defi Explained: Liquidity Pools

Liquid…like water?

For a given market to be efficient, whether it be bonds, stocks, precious metals or cryptocurrencies, it needs to be liquid. But what exactly does that mean?

Liquidity describes how easy it is to convert an asset to cash without affecting the price. If you buy Apple stock on the NYSE (New York Stock Exchange), the bid (buy) and ask (sell) price will be very close to each other, because many people and machines are interacting on the same, very popular market.

When you buy just one stock, the price move will be so insignificant that you will barely notice. On the contrary, if you were to buy one of the more recent “hype coins” called Safemoon, even small quantities would cause relatively significant price moves, because once the hype dies down, there are fewer and fewer people interacting with the asset, and the liquidity “dries up”.

A centrally managed ocean

In traditional markets, and more specifically on centralized exchanges, the liquidity is ensured by the exchange. The exchange needs to make certain that at any given time for a listed trading pair, there is sufficient quantity of the quoted token if someone were to place an order for it.

A fundamental problem with this paradigm is that the liquidity is managed centrally by the provider, in this case the exchange. How can this be done in a decentral manner? This is where liquidity pools come into play.

Dive deeper

Most liquidity pools are implemented as protocols via smart contracts that run on Ethereum, or more recently the Binance Smart Chain (BSC). Providers to the protocol, called liquidity providers, can participate in a liquidity pool by depositing their tokens into a specified contract, which usually returns a token that represents the user’s share in the pool. When other users take advantage of the newly provided liquidity to make trades, the larger part of the fee generated by the trade is paid out to the liquidity providers, proportional to how much liquidity they provided.

The most fascinating aspect of this complex dance becomes obvious when the smart contracts of the liquidity protocol run on a decentralized blockchain such as Ethereuem: the centralized market maker is replaced by an automated market maker (AMM), and the exchange of assets can now take place without the control of a single entity. Instead, the healthiness of the market is determined solely by the quality of the underlying code and the behavior of its participants.

This process can be abstracted one level further. If you want to optimize your returns by weighing multiple pools of varying protocols against each other, you can opt for liquidity mining, and we’ve already described this process in detail here.

A fresh frontier

Liquidity pools are still in their nascent stages. Centralized exchanges have had decades to perfect their trading engines and security measures, and catching up to these standards, in addition to offering it all decentrally, is no insignificant feat for decentralized protocols such as Uniswap, PancakeSwap, and others. Gaping organizational, market, and security vulnerabilities such as rug pulls, arbitrage, and flash loans are rampant with this technology in its early stages. Invest and provide liquidity at your own risk!

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