Crypto Liquidity Pools – The Foundation of DeFi Exchanges
Guide to Crypto Liquidity Pools

Definition of Crypto Liquidity Pools

Crypto liquidity pools are crowdsourced funds of crypto coins and tokens locked in a smart contract. Liquidity pools primarily serve to facilitate automated and permissionless trading between crypto currencies and tokens on decentralized exchanges (DEX). Decentralized exchanges allow users to swap one cryptocurrency for another by executing a trade against a liquidity pool. 

Basic liquidity pools are two-sided and therefore lock two different types of crypto coins. To provide liquidity to a basic pool on decentralized exchanges (DEX), liquidity providers (LP) must add an equal value of both coins to the pool. In return for locking their funds, liquidity providers receive LP tokens proportional to their share of the liquidity pool.

Difference between Crypto Liquidity Pools and Traditional Solutions

Crypto liquidity pools play an essential role in the Decentralized Finance (DeFi) ecosystem as they solve the problem of limited liquidity on decentralized exchanges. Without liquidity pools, traders face huge downside risks and high slippage which makes trading on exchanges inefficient. 

Centralized exchanges are based on order book management systems to coordinate trades and guarantee instant transactions. However, implementing a traditional order book management system in decentralized finance systems results in slow transactions and poor user experience. As on-chain transactions require gas fees for interaction, updating orders would be incredibly expensive. 

Ethereum, for example, is limited to processing 12-15 transactions per second, therefore, it is nearly impossible to transfer order system managers to decentralized solutions. To solve this issue, decentralized exchanges developed crypto liquidity pools. Thus, liquidity pools are the gateway to offering efficient on-chain solutions for exchanging crypto currencies and tokens. Layer 2 technologies are another means to solve Ethereum’s scalability issues.

Functionality of Basic Crypto Liquidity Pools

This image shows the functionality of crypto liquidity pools and how it works.

Most liquidity pools are basic two-sided pools, therefore, they facilitate trades between two different coins. For example, Ethereum / Tether pools allow users to exchange their Ethereum coins for Tether coins. Trading activities, such as exchanging coins, are managed by the algorithm encoded in the smart contract.

Asset pricing in crypto liquidity pools

Similar to traditional financial markets, trading prices depend on supply and demand. Automated market makers define pricing based on the ratio of the coins in the pool. To guarantee reliable transactions and reduced slippage, the pool’s algorithm uses simple mathematical equations to maintain a balanced pool. 

Decentralized exchanges like Uniswap commonly use the basic equation x*y=k to ensure efficient trading. Both, x and y represent one of the pool’s assets and k is a constant. Consequently, multiplying the price of asset x and asset y must always equal the same number.

Since the price of asset x multiplied by the price of asset y must equal k, a large deposition of asset x to the pool must result in a price increase of asset y. If a large number of coin x is added to the pool in exchange for asset y, supply of asset y is shorted. Thus, trading asset y in return for asset x will be more expensive after the large deposition.

Large pools have a lower risk of slippage as they can accommodate bigger transactions without great changes in prices. DeFi exchanges therefore incentivize liquidity providers to lock more tokens in crypto liquidity pools. 

This image shows the way asset pricing works in crypto liquidity pools.

Incentivizing Methods

Instead of relying on buyer and seller matching for transactions, crypto liquidity pools are based on automated market makers (AMMs). Automated market makers are autonomous trading mechanisms that incentivize users to contribute liquidity to the pool in return for a share of trading fees and liquidity provider tokens (LPs).

Liquidity providers must provide an equal value of both coins to the respective pool in order to realize their rewards. As an equal value of both crypto currencies is added, the liquidity pool’s composition is not changed. Thus, liquidity provisions do not influence the rates at which the coins in the pool can be traded.

In return for depositing their funds into the smart contract, liquidity providers receive a percentage of future trade fees and LP tokens. Hence, trading fees of future transactions involving the pool, are split between all liquidity providers. Additionally, governance tokens can be issued, granting liquidity providers voting rights for decisions concerning the pool. 

The share of trading fees that liquidity providers receive depends on the number of LP tokens that they hold. LP tokens are handed to liquidity providers in proportion to the amount of coins that they have locked in the pool’s smart contract. To exit a crypto liquidity pool, providers can claim their asset contribution by burning their LP tokens. After burning their LP tokens, liquidity providers lose their right to earn shares of the pool’s trading fees.

Yield Farming and Crypto Liquidity Pools

Yield farming allows additional incentivization methods to motivate liquidity providers to lock tokens in smart contracts of particular “incentivized pools”. As liquidity providers usually distribute their funds to liquidity pools with the highest yield, DeFi exchanges can control liquidity provision to some extent.

To maintain consistent liquidity in pools and therefore securing reliable trading, liquidity mining is facilitated. Liquidity mining includes the distribution of additional tokens or incentivizing liquidity providers through higher trading fees. Additional rewards serve as a compensation for the additional risk liquidity providers may have to deal with. 

Different DEX protocols are composed of different algorithms

Besides basic liquidity pools, there are different algorithms for various DEX protocols. As explained in the previous sections, basic liquidity pools use constant product market makers and are two-sided. Other protocols, like the algorithms used by Curve and Balancer, offer additional functions such as specialized pools for stable coins and multiple token pools.

One deficiency of basic liquidity pools is that automated market makers do not work effectively for assets with similar prices. The decentralized exchange Curve addressed this issue by developing a slightly different algorithm. Curve pools offer lower wages and slippage for similarly priced assets such as stable coins. 

Another limitation of basic liquidity pools is that they are two-sided. For that reason, Balancer invented another protocol allowing up to eight assets in a pool. Whilst basic liquidity pools usually use simple mathematical relationships, Balancer uses the more complex constant mean formula. 

Risks of Locking Assets in Crypto Liquidity Pools

Risks associated with crypto liquidity pools include impermanent loss, smart contract risks, DeFi scams and liquidity pool hacks. Impermanent losses commonly occur when the price ratio of the assets in the pool fluctuates. If the pool price is lower than the real-world value of the asset, liquidity providers suffer from arbitrageurs resulting in a temporary loss for liquidity providers.

Impermanent losses only become permanent when liquidity is claimed and taken out of the pool before the price ratio reverts. If liquidity providers continue to lock their assets in the pool, the price ratio may revert and the initial book loss is balanced out. Even though impermanent losses may reduce the value of liquidity providers’ funds,  they often continue to provide liquidity as earnings from transaction fees potentially exceed realized losses. 

In addition, smart contract risks, DeFi scams and liquidity pool hacks must be considered before providing liquidity to a pool. As the contract of the crypto liquidity pool is practically the custodian of your funds, smart contract bugs may lead to permanent fund losses. Likewise, DeFi scams are projects where developers have privileged access within the smart contracts code enabling them to control some funds.

This image shows the different risks that come with participating in crypto liquidity pools

Key Takeaways

Crypto liquidity pools are a core technology of the fastest growing crypto sector and therefore shaping further DeFi advancements. As automated market makers allow decentralized trading, they support the trend towards eliminating central authorities from transactions. Liquidity pools are the gateway to offering on-chain trading services and thus highly important when it comes to future DeFi developments.

Author: Klara
Published: 2022-03-04

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