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

Along with the matching engine, the order book is the core of any centralized exchange (CEX). This model is great for facilitating efficient exchange https://www.xcritical.com/ and allowed the creation of complex financial markets. 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. A liquidity pool is basically funds thrown together in a big digital pile.

Trade Execution and Pool Balance

This covers voting on issues including changes in the pricing structure, protocol improvements, new pools and other governance suggestions. This democratic model guarantees users’ voice what is liquidity mining in forming and running the platform community. A liquidity pool is essentially a reserve consisting of cryptocurrencies that are locked in a smart contract together.

What are some common examples of liquidity pools?

• You could go buy a bunch of ETH from that pool and sell it to Coinbase and make $50 off every ETH you sell.
• Whether it’s a low cap cryptocurrency or penny stock, slippage will be a concern when trying to enter — or exit — any trade.
• Liquidity pools are a revolutionary concept in the DeFi space, allowing for efficient, decentralized trading while offering lucrative earning opportunities for liquidity providers.
• With the Order Book, sellers will set the minimum price of the assets they want to sell, and buyers will set the maximum price they are willing to pay for such assets.
• And in many cases, these funds are either non-recoverable or only partially recoverable.

Liquidity pools are the backbone of many decentralized exchanges (DEXs), representing a paradigm shift in how trades are made and orders are filled. At their core, they are blockchain smart contracts that lock up funds, creating a pool of tokens that users can trade against. This technology functions via a mechanism that allows users, or liquidity providers (LPs), to pool their digital assets in a DEX’s smart contract. In exchange, the LPs receive certain rewards (typically in the form of trading fees) in proportion to the liquidity they supplied.

Liquidity pools eliminate middlemen and centralized entities

DeFi protocols can differ in their liquidity protocols structure; one might charge higher fees, and one might distribute tokens that don’t have governance rights, etc. Examples of liquidity pools include Uniswap, Balancer, Bancor, and Curve DAO. Unfortunately, this “mercenary capital” undermines DeFi protocols’ sustainability for the entire ecosystem. In this example from Uniswap, the price of Token A increases from 1,200 to 1,203.03, which decreases the value of Token B to 399 to preserve the constant of 3. After the transaction, the liquidity shares are worth 3.015 after adding transaction fees.

What Is a Crypto Liquidity Pool? Why Are They So Important to DeFi?

Market makers gain money by buying assets at reduced rates and selling them at higher prices. This configuration guarantees that there is always an individual willing to purchase or sell an asset, thereby preserving market liquidity. Most liquidity pools also provide LP tokens, a sort of receipt, which can later be exchanged for rewards from the pool—proportionate to the liquidity provided. Investors can sometimes stake LP tokens on other protocols to generate even more yields. If you’re providing liquidity to an AMM, you’re probably exposed to impermanent loss. Make sure to read our article about it if you’re considering putting funds into a two-sided liquidity pool.

What Are Liquidity Pools in DeFi and How Do They Work?

This is the risk that the smart contract that governs the pool can be exploited by hackers. It should be noted that liquidity pools with assets of low volatility such as stablecoins have historically experienced the least impermanent loss. The assets in the pool are analogous to the lemonade machines, and the users who supply those assets are like the friends who invested in the business. SushiSwap (SUSHI) and Uniswap are common DeFi exchanges that use liquidity pools on the Ethereum network containing ERC-20 tokens. In this context, liquidity refers to the availability of a particular asset in the pool, allowing trades to occur without significant price slippage.

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A centralized exchange like Coinbase or Gemini takes possession of your assets to streamline the trading process, and they charge a fee for the convenience, usually around 1% to 3.5%. Users can create liquidity pools, allowing them to tailor their liquidity provision strategies based on their preferences. Certain platforms provide hybrid pools that integrate the characteristics of both single-asset and multi-asset pools. These pools have the potential to offer increased adaptability and meet the specific requirements of the DeFi ecosystem. Liquidity pools operate in a highly competitive environment where competitors constantly chase higher yields.

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The larger the liquidity pool, the less impact large trades will have on the asset’s price, contributing to a more stable and efficient market. Some of the 2nd layer scaling projects like Loopring look promising, but even they are still dependant on market makers and they can face liquidity issues. On top of that, if a user wants to make only a single trade they would have to move their funds in and out of the 2nd layer which adds 2 extra steps to their process. Some projects also give liquidity providers liquidity tokens, which can be staked separately for yields paid in that native token. This is a bit confusing, but the difference is more than just semantics. We also talked about a liquidity pool being a combination of at least two tokens locked in a smart contract.

This can enable them to potentially do something malicious, like taking control of the funds in the pool. Read our DeFi scams article to try and avoid rug pulls and exit scams as best you can. You could think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book. For example, trading on Binance DEX is peer-to-peer since trades happen directly between user wallets. The system that matches orders with each other is called the matching engine.

Without a smart contract audit, they could use this to do something bad, like take control of the pooled funds. There is an opportunity for fraud in a highly centralized liquidity pool. For example, one of the developers in the pool can hijack the pool’s resources. As a result, you must select your liquidity pool carefully and conduct adequate due diligence before depositing your crypto.

There’s also a risk that the smart contracts underlying DeFi protocols could be hacked, exposing funds locked in the protocol. For example, ChainSec’s logs show a total of nearly 150 DeFi exploits amounting to more than $4 billion in lost funds. And in many cases, these funds are either non-recoverable or only partially recoverable. In this article, you’ll learn how liquidity pools work under the surface and how that impacts the DeFi ecosystem, including investors, borrowers, and other participants.

Liquidity pools are created when users (called liquidity providers) deposit their crypto assets into a smart contract. When users add their assets to a liquidity pool these assets are used to enable trades on exchanges. Each trade generates a fee shared among the liquidity providers according to their contribution to the pool. This setup ensures there’s always liquidity for trades, reducing price fluctuations and improving trading efficiency. Different platforms and protocols have unique models for managing liquidity pools while providing liquidity for various markets and assets.

The most significant of these is impermanent loss, which can occur if the price of the underlying assets in the liquidity pool changes significantly compared to when they were deposited. A liquidity pool represents cryptocurrency locked in a smart contract on a DEX (decentralized exchange). When a new pool is created, the first liquidity provider is the one that sets the initial price of the assets in the pool.

BitDegree aims to uncover, simplify & share Web3 & cryptocurrency education with the masses. Join millions, easily discover and understand cryptocurrencies, price charts, top crypto exchanges & wallets in one place. Now that you have a better idea of what liquidity pools are and how they work, let’s explore the concept of why anyone would want to use these pools in the first place. However, expected price changes and flash loan attacks can also impact the value of assets in a liquidity pool. In its basic form, a single liquidity pool holds 2 tokens and each pool creates a new market for that particular pair of tokens.

When you’re buying the latest food coin on Uniswap, there isn’t a seller on the other side in the traditional sense. Instead, your activity is managed by the algorithm that governs what happens in the pool. In addition, pricing is also determined by this algorithm based on the trades that happen in the pool.

The importance of liquidity pools is better understood when we compare them with traditional order books. The exact amount earned by any liquidity provider will depend on the size of the pool, the decentralized trading activity, and the transaction fees that are charged. 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.