With the expansion of DeFi (Decentralised Finance), many users have been exposed to new opportunities for passive income. The usage of decentralised exchanges (DEXs) has also exploded, which has led to new solutions for liquidity and smooth operation. You may have heard of one such solution in “liquidity pools”. So what are liquidity pools and how does a liquidity pool work?
What Are Liquidity Pools?
The first technology to understand before delving into liquidity pools is smart contracts. Smart contracts are sets of code on a blockchain that execute automatically when their conditions are met. First popularized by Ethereum in 2015, they now form the backbone of all decentralized applications, particularly in the DeFi space.
Definition of Liquidity Pools
A liquidity pool is a store of funds locked into a smart contract. These funds are crypto assets deposited by users, which are then lent out to individuals and protocols. They form the basis for many DEXs to function since liquidity is essential to having a smooth and seamless trading experience.
How Do Liquidity Pools Work?
Any decentralised protocol will allow you to lock your funds in a liquidity pool. When you lock your funds in, you earn interest and rewards in the form of crypto tokens in return for lending your assets. This can be a compelling crypto income source for many individuals.
On a platform like Uniswap, you are required to deposit two tokens of equal value. For example, assume ETH is worth $2 and USDC is worth $1. When you lock your tokens in, you would have to deposit an equivalent amount of ETH and USDC. This allows users to trade directly with the liquidity pool.
The Role of Liquidity Pools in Decentralized Finance (DeFi)
Early DeFi protocols only allowed you to trade with other individuals on the platform, which is known as peer-to-peer trading. This can be very slow and finicky, as you must find a counterparty willing to buy or sell the exact amount of tokens you want at the price you demand.
Today, you can trade directly with a smart contract. In liquidity pools, there is no counterparty who has to match your order, your tokens come straight from the provided funds. This has led to trades being completed in just a few seconds, with significantly greater liquidity in the market.
Advantages of Using Liquidity Pools
Improved Liquidity For Assets
Having an order book or P2P system makes it difficult to trade tokens with low traded volumes. Liquidity pools solve this by having an easily accessible store of tokens for you to trade from. It makes it possible to trade in smaller and less frequently traded assets quickly.
Reduced Slippage in Trades
Slippage refers to the difference between the price you choose to trade an asset for and the final price at which it executes. Slippage can be very high on assets with low liquidity since crypto is a volatile asset class. The price can change between when you initiate the trade and when it is finalized. Liquidity pools mitigate this problem by increasing the liquidity available to DEXs.
Potential for Earning Passive Income Through Liquidity Provision
One of the biggest draws of liquidity pools is the potential to earn rewards from them. These rewards are in the form of special LP (Liquidity Provider) tokens, which can sometimes be staked to further increase returns. Providing liquidity can thus be a stable source of income for many investors.
Read more: What is Crypto Staking
Liquidity Pool Risks and Considerations
Volatility of Assets in the Pool
Crypto is a highly volatile asset class. When you deposit tokens, there can be a lengthy lock-in period during which you cannot remove your tokens. During this time, the price of tokens can fluctuate wildly. This can also adversely affect your returns as the value of your asset falls.
Smart Contract Risks
This risk varies from platform to platform. If the smart contract or blockchain used by a particular protocol has vulnerabilities, they can be exploited by malicious actors. This can put your funds and the seamless functioning of the platform at risk, resulting in lower returns.
Market Manipulation and Frontrunning
Collusion or insider trading in the crypto market can cause huge price swings in a short time. This can be detrimental to your investment and reduce your earning potential significantly.
Read more: Crypto Investing vs Crypto Trading
Liquidity Pool Use Case
The most common use case for liquidity pools is in DEXs, as mentioned above. The automated market maker system extensively utilises liquidity from the pools to fulfil orders. However, there are many other problems that liquidity pools have been used to solve.
They can also be used for DeFi lending and borrowing. Borrowers can take a loan on a DeFi platform and draw the funds from a liquidity pool. In exchange, they also have to put up collateral so that the loan is secured.
Alternatively, liquidity pools can also be used in governance. If the number of tokens required to vote on a blockchain platform is too high, users can deposit their tokens into a liquidity pool and combine their funds to govern the platform.
Recap of Key Points
Liquidity pools are smart contracts that hold funds for lending. These funds can be used for liquidity on DEXs, lending to individuals or even for governance. The pros of such an approach include faster trades and the potential to earn rewards. However, they also carry risks such as high volatility and the chance of hacks.
Future Outlook for Liquidity Pools and DeFi
Liquidity pools have led to the rapid growth of DeFi. They have aided its expansion from a small hobby to rival what traditional finance offers. As long as DeFi remains popular, so will liquidity pools.
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FAQs on Liquidity Pools
Are Liquidity Pools Safe?
Most liquidity pools and protocols are safe to deposit your funds into. They may be open-source platforms, in which case you can manually verify whether the platform is secure. Be sure to do your research before putting your hard-earned money into a platform.
Are Liquidity Pools Profitable?
Depositing your funds in a liquidity pool allows you to earn returns ranging from 10-25% per annum, which is very profitable and less volatile than directly trading crypto assets.
How Do You Make Money From Liquidity?
In exchange for the liquidity you provide, you receive new crypto tokens known as LP tokens. You also receive a percentage of all platform fees, based on how much liquidity your funds have created. These are the main ways to earn money from liquidity.