What are Liquidity Pools in Crypto?

Liquidity pools are one of the most important factors of the DeFi (Decentralized Finance) ecosystem. It is a digital supply of cryptocurrency that is secured by a smart contract. As a result, liquidity is produced that allows for quicker transactions. The article focuses on discussing the liquidity pool in the blockchain. The following topics will be discussed here:

1. What is a Liquidity Pool?
2. Purpose of Liquidity Pool
3. Why Liquidity Pools are Important?
4. How does Liquidity Pool Work?
5. Role of Liquidity Pool in DeFi
6. Risks of Liquidity Pool
7. Pros of Liquidity Pool
8. Cons of Liquidity Pool
9. Earning on Liquidity Pool
10. Popular Liquidity Pools

Let’s start discussing each of these topics in detail.

What is a Liquidity Pool?

Liquidity pools refer to the collection of tokens locked in a smart contract that provides essential liquidity to decentralized exchanges. Liquidity pools are an essential part of Automated Market Makers (AMM), yield farming, borrow-lend protocols, on-chain insurance, etc. AMM is a type of protocol in which digital assets are traded in an automated and permissionless state rather than being traded by the seller and the buyer, like a traditional market way. Liquidity pools serve the appetite for high rewards for taking a high risk.

• Liquidity pools are created when users lock their cryptocurrency into smart contracts and enable them to be used by others.
• These are crowdfunded reservoirs of cryptocurrencies that anybody can access.
• These are the backbone of many decentralized exchanges (DEX).
• They are used to facilitate decentralized trading, lending, etc.

Purpose of Liquidity Pool

• Eliminate issues of the illiquid market: Liquidity pools eliminate issues of the illiquid market by providing incentives to its users and liquidity for a share of trading fees.
• Eliminates gap between buyer and seller: Think of the traditional market, where there is the concept called the Order Book Model in which the buyer and seller place their respective orders. Here the buyer tries to buy the assets at the lowest price possible and the seller tries to sell the assets at the highest price possible. Basically, both the buyer and the seller have to come up with a price where both are been satisfied by their respective assets, right? What if there are no such worries about agreeing on fair-price assets for both buyer and seller? Or, what if the record is not been executed properly? So here the AMM and the liquidity pools concept comes into light. So there is no need for the buyer to wait for buying his assets at a fair price and also for the seller to sell his assets at a fair price. Liquidity pool protocol doesn’t require the buyer’s and the seller’s matching. In the simplest way, the liquidity pool eliminates the gap between the buyer and seller, making them trade on the DEX (Decentralized Crypto Exchange) easily and safely.
• Simple and efficient: A liquidity pool allows you to simply and more efficiently exchange assets between each other by providing a steady supply of buyers and sellers.
• Automated trading: As we all know the problem with market makers is that they mostly provide unprofessionally slow and pricey transactions, and users need to rely on such market makers. But the Liquidity pool fixes this issue through automated trading.
• Facilitate peer-to-peer trading: The primary goal of liquidity pools is to facilitate P2P trading DEXs.

Why Liquidity Pools are Important?

Below are some of the reasons why liquidity pools are important:

• Enables users to trade on DEX: Liquidity pools provide liquidity that is necessary for decentralized exchanges on DEX by allowing users to deposit their digital assets into a pool and then trade pool tokens on the DEX.
• Eliminate middlemen: Liquidity pools eliminate centralized exchanges by using AMM to set prices and match buyers and sellers.
• Providers get incentives: Liquidity pools provide liquidity providers the opportunity to earn interest on their digital assets. By locking the tokens in the smart contract the users can earn a portion of fees that are generated from trading activity in the pool and thus helps them to make sure that there is enough liquidity in the pool to support trading on DEX. 

How does Liquidity Pool Work?

Two tokens or cryptocurrencies constitute a liquidity pool. For creating a liquidity pool there will be two cryptocurrency token

• One is self-created cryptocurrency.
• Another one will be the most used cryptocurrency token whether it be ETH, BNB, etc., or some (stable coins). 

The pool is divided into a ratio of 50:50. The pool’s creator determines the initial price for the assets. Thus, for giving value to self-created cryptocurrency the user needs to be the first person/liquidity provider to the token (on which the price of the token can be decided). By doing so user can create their own liquidity pool. If the pool’s pricing does not match that of the global market then the liquidity provider is at risk of losing money.

• The pricing algorithm is responsible for adjusting the price of two tokens as the liquidity pool supports token swaps.
• Each liquidity pool can use its own methodology to calculate the asset price.
• The transaction fees that others pay to buy and sell from the liquidity pool pay the liquidity pool providers. 
• The liquidity pool providers reinvest those transaction fees in the pool and thus helping to boost the value of tokens and expand the pool.

Example: 

1. Suppose there are two tokens in the liquidity pool:

• TK: Created Token.
• ETH: Ethereum cryptocurrency.

2. The liquidity pool [LP] is a pool with 6000 TK and 6000 ETH each and the price of 1 TK = 1 ETH so, for 1000 TK = 1000 ETH.

3. Suppose a buyer wants to buy 100 TK (tokens) from the liquidity pool so he needs to make a payment of 100 ETH in order to get the 100 TK.

4. The buyer makes a payment of 100 ETH and buys 100 TK from the Liquidity Pool. LP2 i.e. the new liquidity pool, it will be now used to set the price of the token at another stage of the action when someone buys the token. The liquidity pool will look something like this:

5. Remaining TK is 5900 and ETH has been increased by 100 ETH i.e. total of 6100 ETH.

Every time a buyer buys the TK, the price of the TK will increase because the demand for our token has increased.

So the price of the token here has been increased by 1.033898305084746.

TOKEN PRICE

In this way the Liquidity pool works, each new buyer goes on buying the token the price for the same also increases in that manner. 

Role of Liquidity Pool in DeFi

1. Acts as backbone: Liquidity pools act as the backbone of the DeFi (Decentralized Finance) protocol’s crucial activities. 
2. Provides liquidity: Liquidity pools provide liquidity, speed, and convenience to DeFi system.
3. Provides a mechanism to pool assets in DEX: Liquidity pools provide a mechanism to pool assets in DEX’s smart contract to provide asset liquidity for traders to swap between currencies. 
4. DeFi protocols: Many activities which run on blockchain technology having DeFi protocols are been mostly integrated with the liquidity pool concept. 

Risk of Liquidity Pool

• Impermanent loss: One of the most common risks involved in the liquidity pool is impermanent loss. The AMMs work in the way that the price of the token changes compared to the price when they were been deposited into the liquidity pool. The more the change, the bigger the loss is. Though sometimes this loss is negligible sometimes it may be crucial too. It is a loss in dollar value compared to HODLing when liquidity is being provided to AMM.
• Smart contract risk: When funds are being deposited into a liquidity pool then they are in the pool. It may happen that there is some code error while creating the smart contract, and this change cannot be done as we usually do to normal codes. The whole smart contract needed to be changed on the blockchain. So in short the changes made and the deployed smart contracts are been stored on the blockchain permanently. So if any vulnerability is found in the smart contract then the loss of the tokens is permanent.
• Rug pull: When the price of the token goes higher and the amount of, suppose ETH in our example goes on increasing in the pool, so the pool creator doesn’t look for his kind of token value instead he looks for the ETH whose amount/balance has been increased in the liquidity pool. And what they do is once this amount gets bigger and bigger at some point the Liquidity pool creator/developer abandons or closes the project removing all the money/cryptocurrency and running away. So before investing in any of the liquidity pools make sure it has a liquidity lock associated with it.

Pros of Liquidity Pool

• No waiting needed: As there is no involvement of the buyer and seller to come up with the desired price, making users buy and sell the assets as per their requirements.
• Good earning: LP rewards are provided to the LPs using the concept of yield farming. Also, many such earnings are been executed towards the liquidity pools by the liquidity pool owners.
• Low market impact: The values of the token are been updated depending on the exchange rates.
• Simplifies DEX: Liquidity Pool simplifies DEX trading as transactions are being performed at real-time market prices.
• Keep security audit information transparent: The liquidity pool uses publicly viewable smart contracts, thus keeping security audit information transparent.

Cons of Liquidity Pool

• Rug pull: Liquidity pool creator/developer abandons or closes the project removing all the money/cryptocurrency and running away. So before investing in any of the liquidity pools make sure it has a liquidity lock associated with it.
• Smart-contract vulnerability/bugs: As these pools are built on the smart contract it may happen that there can be code error in the smart contract causing hackers to find bugs or vulnerabilities and exploit the smart contracts. This can cause a huge loss to the whole system.
• Slippage: Slippage occurs when the price which you have anticipated differs from the price which you are actually getting. So the larger you trade, the more the liquidity which is present in the pool becomes imbalanced and tends to create overall price slippage. Slippage can be avoided by using more gas, adjusting slippage tolerance, or breaking larger trades into smaller chunks. 
• Risk of access: Before going to any liquidity pool check the projects whether the designers can modify the rules of the pool in the way they want or not. Also, additional access to code or smart contracts may be available to developers, do look out for that also. This might give them an opportunity to change any rules codes, etc., and might lead to cause harm, such as seizing the pool money.
• No decentralization: In liquidity pools, the pool of funds is under the control of a small group of people that don’t believe in the concept of decentralization.
• Exposure to impermanent loss: Impermanent loss happens when the price of the assets locked up in the liquidity pool changes and creates an unrealized loss 

Earning on Liquidity Pool

1. Yield Farming: The concept of Yield farming (also called Liquidity mining) is used here. The basic idea behind yield farming is that the users are given token rewards in exchange for providing liquidity into the pool. The Person who puts money/tokens in the liquidity pool is called the liquidity provider, and the rewards provided to them are called LP rewards or LP fees. This concept is a little how similar to the banking system, where interest is collected on the deposited assets.
2. LP rewards: These LP rewards are being collected by the swaps which are been taking place in the pool. And every LP provider is given their respective LP reward on the basis of the proportion to their shares. 
3. Airdrops: Another earning is based on the airdrops. The Liquidity pool creator may airdrop the token to all the LPs who have been provided the liquidity into the pool.  
4. Referral learning: Also referral earning plays an important role here, all the LPs are given their respective referral keys which they can use to invite other users into the liquidity pool. And as a token of appreciation, the user who invited the referral user gets some amount of reward, and also every time the referral user swaps their token some commission fee is been transferred to the user who has been given the referral.

Popular Liquidity Pool Providers

There are many liquidity pool providers out there, but some of the most popular liquidity pool providers are:

• UNISWAP: One of the most used platforms for liquidity pools. It is a decentralized ERC-20 token exchange that supports 50% of the ETHEREUM contracts and 50% of the ERC-20 token contracts. This platform charges 0.3% of the exchange fee, which is divided among the liquidity providers.
• CURVE FINANCE: Another most used platform for liquidity pools. It is a decentralized liquidity pool for stablecoins which are been traded on ETHEREUM. As it provides stable coins liquidity pool the risk of loss is also not high here.
• BALANCER: This is built on the ETHEREUM, it’s a non-custodial portfolio manager. It supports various pooling options such as shared, private, and smart pools. Though in the private pool only the owner has complete permission to provide liquidity and make any changes to the pool.
• BANCHOR: A blockchain-based technology built on ETHEREUM. It also uses the algorithmic market-making method, which uses smart-contract. This platform is also similar to UNISWAP, CURVE, and many others. This platform charges between 0.1% to 0.3% depending on the pool status.