Liquidity pools are one of the foundational technologies behind the current DeFi ecosystem. They are an essential part of automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, blockchain gaming – the list goes on. Let’s explore how DeFi iterated on the idea of liquidity pools.
Introduction
Decentralized Finance (DeFi) has created an explosion of on-chain activity
- DEX volumes can meaningfully compete with the volume on centralized exchanges
- There are almost 15 billion dollars of value locked in DeFi protocols
- The ecosystem is rapidly expanding with new types of products
What is a liquidity pool?
A collection of funds locked in a smart contract
- Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market
- In exchange for providing their funds, they earn trading fees from the trades that happen in their pool
The risks of liquidity pools
impermanent loss
- A loss in dollar value compared to HODLing when you’re providing liquidity to an AMM
- Another thing to keep in mind is smart contract risks
- When you deposit funds into a liquidity pool, they are in the pool
- Beware of projects where the developers have permission to change the rules governing the pool
Liquidity pools vs. order books
Order books are the core of any centralized exchange (CEX).
- DeFi trading involves executing trades on-chain, without a centralized party holding the funds.
- Each interaction with the order book requires gas fees which makes it much more expensive to execute trades.
- Most blockchains can’t handle the required throughput for trading billions of dollars every day.
Closing thoughts
Liquidity pools are one of the core technologies behind the current DeFi technology stack
- They enable decentralized trading, lending, yield generation, and much more.
- These smart contracts power almost every part of DeFi, and they will most likely continue to do so.
How do liquidity pools work?
A liquidity pool is a bunch of funds deposited into a smart contract by liquidity providers.
- When executing a trade on an AMM, you don’t have a counterparty in the traditional sense – you’re executing the trade against the liquidity in the liquidity pool.
- Your activity is managed by the algorithm that governs what happens in the pool.
What are liquidity pools used for?
AMMs
- Liquidity pools are the basis of automated yield-generating platforms like yearn, where users add their funds to pools that are then used to generate yield.
- They can be used in a number of different ways including yield farming, liquidity mining, governance, insurance against smart contract risk and tranching.
