What Are Liquidity Pools in DeFi and How Do They Work?
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.