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How Do DeFi’s Liquidity Pools Work?

November 23, 2021

Christina

How Do DeFi’s Liquidity Pools Work?

Liquidity pools are arguably the most revolutionary of all the innovations in the decentralized finance (DeFi) space. Pioneered by decentralized exchanges such as Uniswap and Bancor, liquidity pools are now a highly competitive segment.

At the time of writing, stablecoin trading platform Curve Finance is the most popular DeFi application by value locked, holding over $13 billion worth of assets across five platforms. 

Unlike lending applications, which operate on principles familiar to those entering crypto from traditional finance, liquidity pools are an entirely new proposition unique to DeFi. As such, they can be intimidating to newcomers. This guide explains how liquidity pools work, how they benefit the DeFi ecosystem and its users, and some of the watch-outs. 

The Case for Liquidity Pools in DeFi

If you have come to DeFi from traditional finance, you may question why liquidity pools are even necessary. After all, centralized finance relies on the order book model, where buyers and sellers agree on prices facilitated by market makers. 

Earlier versions of decentralized exchanges attempted to replicate this concept, but none gained sufficient liquidity depth to make trading attractive. Early DEXs were Ethereum-based applications, so high transaction fees and slow block confirmation times acted as a deterrent to market makers. Other blockchain platforms didn’t have the user numbers. As such, the innovators stepped in, and liquidity pools were the result. 

How Does a Liquidity Pool Work? 

Uniswap’s dual-token pools are the simplest example, so we’ll use the biggest Uniswap pool, which happens to be USDC and ETH, to illustrate how liquidity pools work. At its core, the liquidity pool is a smart contract that manages the supply of both USDC and ETH. This smart contract is called an automated market maker (AMM). 

Anyone who uses Uniswap to trade ETH for USDC or vice versa is a user of this pool. When someone makes a trade, they pay a flat fee of 0.3% regardless of how much or how little they trade. 

For this model to work, the pool needs to have a continuous supply of USDC and ETH, which is where liquidity providers come in. Let’s assume today’s ETH price is $4,000. A liquidity provider must deposit an equal value of both USDC and ETH, so they contribute 1 ETH and 4,000 USDC. We can assume that many other liquidity providers are doing the same so that when someone wants to swap a token, they can always do so seamlessly. 

When the liquidity provider adds their tokens to the pool, the underlying smart contract will return a “liquidity pool token” representing their stake. They also receive a share of the fees paid by traders who use the pool, which is proportional to the value of their staked liquidity. 

The AMM smart contract underpinning the liquidity pool performs a constant rebalancing exercise, quoting prices according to supply and demand. Uniswap, which operates relatively simply token pools in pairs, has a fairly straightforward AMM, whereas Curve and Balancer, which operate multi-token pools, use more complex AMM models. 

Newer entrants, such as the Cosmos-based Osmosis, allow pool operators the flexibility to determine the rules of their pools by changing fee structures or modifying the AMM pricing algorithm. 

What Are the Benefits of Liquidity Pools? 

In the context of the broader DeFi ecosystem, liquidity pools have been a significant growth factor, bringing in the necessary liquidity to create a sustainable decentralized financial system. DeFi users initially flocked to platforms such as Uniswap for the opportunity to earn transaction fees, but the segment has advanced since then. 

Many projects will offer their own token rewards to those who stake liquidity in their pools, requiring the liquidity pool tokens to be staked separately as evidence in return for generous incentives. Uniswap and Balancer have also distributed governance tokens as rewards to those who use their platforms. 

The low fees and non-custodial nature of liquidity pools are also a significant draw for traders. 

What Are the Risks of Using Liquidity Pools? 

While the benefits are certainly a draw, becoming a liquidity provider comes with a unique set of risks. “Impermanent loss” refers to the fact that the value of pooled assets can fluctuate against one another depending on supply and demand. It may be the case that the value of the assets decreases such that even the addition of trading fees doesn’t cover the losses. And don’t be fooled by the term “impermanent.” Once the liquidity provider withdraws its stake, any losses become permanent. 

Another risk is that liquidity pools have previously fallen prey to market manipulation tactics, particularly smaller pools with lower liquidity. So-called “hackers” use techniques such as flash loans to flood markets with outsized orders and drain smart contracts of funds. Therefore, users should be extremely wary of smaller providers or pools with lower liquidity, as they’re more vulnerable to such attacks. 

Finally, like any blockchain-based application, smart contract risk should be a consideration. Platforms that have undergone a robust audit and are proven over time are generally a more reliable bet than applications based on new or unaudited code. 

The sheer pace of growth in DeFi has been staggering, and liquidity pools are a significant factor in the expansion and the general growing sense of excitement surrounding the decentralized financial segment. As such, they’re sure to be a staple feature of the landscape long into the future. But as with any investment, make sure you do your research. 


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