Smart contracts were what gave birth to DeFi. However, liquidity pools (LPs) are what make DeFi markets viable. Liquidity pools are the backbone of decentralized exchanges as without them they wouldn’t exist. So, how do liquidity pools work?
Why do we need liquidity pools?
In stock exchanges and centralized crypto exchanges, market makers provide liquidity to the market by always buying or selling a given holding. This means retail buys and sellers don’t have to wait hours to find a buyer/seller to match their trade. However, conventional market makers do not work in DeFi.
And Ethereum conducts 12-15 transactions per second and has a blocktime of 10-19 transactions per second. This means that traditional market markers in DeFi would result in an unusable platform that is over priced and egregiously slow. Unfortunately, layer 2 protocols which improve transaction times aren’t a solution here either. This is because this system also relies on market makers. Furthermore, this would mean any time someone wishes to conduct a trade, they would need to deposit and withdraw their assets from the layer 2 protocol. So, this would add a cumbersome two extra steps for one single transaction.
This is why liquidity pools were invented. They provide liquidity to decentralized exchanges.
What are liquidity pools?
A liquidity pool is a place where token holders can lend their tokens so that there is at all times a ready supply of tokens ready when an order comes through a decentralized exchange. In exchange token holders receive a proportional percentage of the fees from all the transactions made. Liquidity pools are a profound invention in that they eliminate the need for a centralized order book.
The basic liquidity pool comprises of two token holdings. One can think of every liquidity pool as it’s own market for that specific coupling of tokens. When a liquidity provider adds liquidity to a pool, they are given LP tokens that are corresponding to the the liquidity they supply. Every trade that is made a fee is dispersed among all the the LP token holders. Liquidity pools therefore allow you to earn interest or passive income on your investment. Depending on the token this can be quite substantial.
No two liquidity pools are necessarily the same. We mentioned market makers above. A key mechanism of liquidity pools is a variation of market makers called AMMs (Automatic Market Makers). And different liquidity pools across converging platforms like Uniswap and PancakeSwap, for example, differ slightly. But essentially the takeaway here is a variant of the automated market makers protocol is omnipresent in liquidity pools.
The larger a pool is, the more easier it is to trade. Therefore, protocols can motivate token holders to join a liquidity pool by rewarding them with additional tokens. This is what’s known as liquidity mining.
Liquidity pools are the backbone of decentralized exchanges. Without them they couldn’t exist.
Liquidity pools versus staking
Liquidity pools are often confused with staking, but there is a big difference, although both of them can be lucrative. Staking you place your coins in a specific place to help secure the network (proof of stake) usually earning transaction fees. Liquidity pools, however, where invented with the sole purpose of lending your money to provide liquidity to the market.
Final thoughts
Liquidity pools have their risks as well. There have been instances of hacks and bugs in liquidity pools before. Still, LPs are a novel invention that are becoming better developed every day. The invention of liquidity pools is what made decentralized exchanges possible and allows it to challange centralized financial structures.
This article is not financial advice. Please do your own research before lending your assets to a liquidity pool.
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Aaron is passionate about blockchain and has been an investor in cryptocurrencies for the past years. He enjoys engaging with other people in the cryptocurrency community online, particularly on Telegram, and learning from experts.
