Liquidity pools and the DeFi ecosystem

Liquidity pools and the DeFi ecosystem

Liquidity pools are collections of digital assets that may be traded automatically using smart contracts and without intervention on decentralised exchanges (DEX). Users of these exchanges do not rely on a central authority to retain their funds but instead conduct business with one another directly. Traditionally financial markets refer to liquidity as the ease with which an asset can be bought or sold without causing significant alteration in the price. However, DEX utilises Automated Market Makers (AMM) as there are no intermediaries, meaning liquidity pools play a crucial role in enabling efficient trading and lending of digital assets. So, AMM are, in effect, algorithms used to calculate the price of an asset, dependant on the number of buyers and seller at any one time. Therefore, liquidity pools and AAM are also essential elements of the ecosystem supporting DEXs. Similar to market makers on traditional exchanges, liquidity pools are a cutting-edge tool for boosting crypto market liquidity.

How liquid pools work

Source: cryptorobin.com

Liquidity pools are created to enable DEX users to trade between different digital currencies; and smart contracts secure digital currencies in liquidity pools. Crypto liquidity pools allow users to pool their assets in DEXs' smart contracts and make it easier for buyers to switch between currencies by giving them access to many assets. “Stakers” give equal amounts of two different tokens to the protocol (one of which is a volatile asset and the other a safe asset) and then employ smart contracts to vary the price depending on the number of seller and buyers. When sellers wish to switch between two digital currencies, they can do so for a small transaction fee; this is how the liquidity pools are rewarded for, in effect, locking up the sellers’ assets. Meanwhile, the stakers who deposit receive liquidity pool (LP) tokens - their share of the pool - in return for two other tokens. The amount is used to determine how many LP tokens stakers receive and the stakers’ investment (in USD), divided by the total value of the pool (in USD), is equal to the number of LP tokens received (in USD) divided by the total number of LP tokens in circulation (in USD). Notably, no third party takes a fee or shares in the profits generated.

List of liquidity pools

Source: Finextra.com

Before AMM were launched, the liquidity of the cryptocurrency market was one of DEX's biggest problems. Furthermore, in traditional finance, cash is a very liquid asset because it is easy to buy, to sell in or to trade other assets such as gold, stocks and shares; but it takes work to change into cryptocurrency. Ether is the most liquid asset in the decentralised finance (DeFi) environment because most DEXs are built on the Ethereum blockchain. However, now that AMM have created liquidity pools, the lack of cash is no longer a problem; these pools give liquidity providers a reason to put assets into them. Also, LP tokens in DeFi render it possible to make assets that are easily changed and can be used more than once, even if invested in a DeFi product or staked in a platform control mechanism. The reason for this is because LP tokens let you stake in a way that is not directly staking. Instead of staking the tokens, you can show that you own them and this helps solve the problem of cash being locked up in crypto.

Liquidity pool advantages

There are many reasons why these cryptocurrency trading pools will continue to be a large aspect of the DeFi scene, including:

• a liquidity pool ensures DEXs have assets/liquidity to enable users to trade.
• liquidity pools help market makers who might be unable to add to a pool's liquidity in any other way.
• by putting their tokens on different DeFi systems, liquidity sources can make money in multiple ways.
• by gaining governance tokens and using them to vote, liquidity providers can participate as to how a protocol is run.
• because anyone can use them, liquidity pools are a democratic - although challenging to regulate since there is no central entity in the event something goes wrong.

What is the significance of liquidity pools?

DeFi liquidity pools are essential for several reasons:

i) financial inclusion: They promote financial inclusion, allowing anyone with an internet connection (regardless of their geographical location) greater access to financial services.

We asked Timo Lehes Co-founder of Swarm (the first regulated DeFi platform globally)for his thoughts: "The composability of liquidity pools will enable investors to construct their own financial products. Soon, we will see liquidity pools with a variety of tokens, representing different asset classes. For example, imagine one with tokenized Tesla, Twitter and Dogecoin, and suddenly you've built your very own Elon Musk ETF.

"This concept is fast becoming a reality. On Swarm today, we have the first liquidity pools with tokenized securities that can be directly swapped for crypto assets like bitcoin or eth, and trading activity is regulated in Germany."

Overall, DeFi liquidity pools play a vital role in driving the growth of decentralised finance, promoting financial inclusion and redefining how financial services are accessed and utilised.

Source: blockchain-council

Some significant applications of liquidity pools

In the world of decentralised trading, liquidity pools have become more commonplace. Some of the most essential applications of cryptocurrency liquidity pools include:

The term "tranching" is used to describe the practice of utilising liquidity pools that categorise financial items according to risk and return. Liquidity providers can then tailor their risk and return profiles using these products.

For financial gain, “liquidity mining” invests in “liquidity pools” on automated yield-generating platforms such as Yearn. This is common practice since it is known to be a lucrative approach for getting more tokens into the hands of the right individuals. Tokens in a liquidity pool are distributed to users based on an algorithm.

Synthetic assets on the blockchain may also be created using liquidity pools. During creation, collateral is added to the liquidity pool and then linked to an authoritative data source. A synthetic token backed by the asset of your choice is created as a consequence.

Another fast-growing sector of the DeFi industry is insurance for smart contract risks; Ensuro is an example of a firm in this space.

Liquidity pools may even be employed for administration purposes. To submit a governance plan, collecting a high number of token votes may be necessary, however, if people participate in the process and work together, they may back a cause they all agree is crucial. Liquidity pools operate in a competitive environment, and attracting liquidity can be a challenge as investors are constantly searching for the best returns available. Nansen, a blockchain analytics platform, reported 42% of yield farmers who provide liquidity to a pool on the launch day exit the pool within 24 hours; by day three 70% will be gone. Furthermore, tracking the best rates on each liquidity pools can be time consuming which has led to the creation of liquidity pool trackers and analytic services such as Pools.FYI or APY.vision.

So, the future of DeFi and liquidity pools looks promising, driven by continued growth, innovation and a shift toward decentralised financial services. But, as the industry matures, challenges such as regulatory compliance, security, interoperability and scalability will need to be addressed to unlock the full potential of these transformative technologies.

WebThis article first appeared in Digital Bytes (15th of August, 2023),
a weekly newsletter by Jonny Fry of Team Blockchain.