Gone are the days when trading was exclusively done by the order book model, where someone willing to sell would have to find someone willing to buy at the same price for the trade to become successful. The presence of market makers willing to buy and sell at any given time would eliminate the liquidity problem. In a world with no transaction fees, this would be the optimal solution, although that’s not the case for crypto markets, where gas fees have been steadily increasing for the past years. DeFi liquidity pools have become the solution to this problem, and here’s exactly why.
Let’s say you put a single pair of different tokens into a pool and you lock them in a smart contract. That single transaction creates a market at which the price of a token depends upon the price of the other, which is why the first liquidity provider (LP) sets the initial price of the assets. This incentivizes the LP to supply an equal value of the two tokens, given that if they decide to diverge from the current global price of any of the tokens, an opportunity for arbitrage will be created and the LP might suffer a capital loss. Consequently, all the following LPs that decide to add more tokens to a liquidity pool must follow the rule of equal value among both tokens. Each token swap occurring in a liquidity pool is followed by a price adjustment set by an algorithm known as the Automated Market Maker (AMM), the mechanism through which the product of tokens can be held constant. For instance, if someone buys ETH from a DAI-ETH pool, the quantity of ETH will decrease, which will then push the price upwards. At the same time, the relative price of DAI will decrease as the AMM will force the quantity of DAI to increase to compensate for the loss of ETH on the pool. A large trade on a small pool will affect the relative prices significantly. Hence, the larger the pool, the bigger the size of trades it can accommodate without seeing big fluctuations in prices.
What are examples of major DeFi liquidity pools?
Uniswap is a decentralized token exchange that operates with a 50% reserve of Ethereum contracts, and another 50% reserve of ERC-20 tokens, such as Maker (MKR), or Tether (USDT). Trading ETH for any of the ERC-20 standard tokens can be done through this open-source platform. It also allows you to provide liquidity to the pool by simply depositing any pair of the supported tokens at a 50/50 ratio — and in exchange, you’ll receive an equivalent amount of Uniswap tokens that will entitle you to collect the proportional amount of a 0.3% fee for every trade taking place at the pool, which is distributed among all Uniswap token holders. The most popular pools on Uniswap include DAI-ETH, ETH-USDT, and WBTC-ETH.
Initially a digital exchange platform, Balancer has transitioned into one of the most exciting DeFi liquidity pools of the moment. In this non-custodial portfolio manager, users create funds based on the cryptocurrencies in their portfolios. These do not need to follow the standard 50/50 proportion that helps keep the AMM constant, as Balancer supports pools with up to 8 different tokens. Moreover, providing liquidity to a Balancer pool is rewarded with the platform's own BAL tokens and a portion of the trading fees whenever the network uses the liquidity that LP has put into the pool to trade. MKR-WETH, BAL-WETH, and WETH-DAI-USDC are among the most popular pools of Balancer.
Based on Ethereum, Bancor is a liquidity pool platform with some interesting features that make it stand out against other competitors. It uses similar AMM mechanisms as Uniswap or Balancer, although it has a varying transaction fee that usually oscillates between 0.1 and 0.5%. Furthermore, its pooling system allows Ethereum, EOS tokens, its own BNT token, and its stable coin USDB. The most popular pools on Bancor include USDT-BNT and USDC/BNT.
What are the risks of DeFi liquidity pools?
One of the most common risks associated with DeFi liquidity pools is a phenomenon known as impermanent loss. When someone is holding a digital asset in their wallet, their market value may increase or decrease as the markets determine their price. However, when a digital asset held at a liquidity pool appreciates with respect to its pairing token, there is room for arbitrage. Outsiders may come to the pool and buy that same asset for a cheaper price, and then sell it in the global markets to gain a profit. If the liquidity provider decides to withdraw their assets at this point, their loss will become permanent, whereas if they leave it on the pool and wait for the prices to match again, their loss will have just been temporary, and therefore impermanent. Note that some platforms, like aforementioned Bancor, offer mechanisms to protect the LPs from impermanent loss (although not in all cases, so read the fine print carefully!).
Another risk that has been faced previously is smart contracts failure. This usually happens when the platforms are not audited or their coding security isn’t secure enough to resist data attacks.
What are the benefits of DeFi liquidity pools?
Becoming a liquidity provider has proven to be a profitable activity that has led to the expansion of platforms like Uniswap. Easing the problem of liquidity for a rapidly growing community not only strengthens the network and facilitates trading, but also allows liquidity providers to earn transaction fees from each trade that happens on their pool. As a result, although the trading platforms that utilize liquidity pools usually specialize in a relatively small number of tokens — unlike larger exchanges or aggregators such as SwapSpace — they can have a thriving ecosystem around them.
Additionally, rewards in the form of platform tokens are a standard incentive for liquidity providers, as the platforms want their token pools to preserve their size and increase it more than anything else. These tokens usually increase their market value as the project unfolds successfully, which has happened over the last month with Uniswap and SushiSwap tokens.
How can I join DeFi liquidity pools?
Each platform keeps its own procedure to gain access to its pools, although, for the most part, a standard Ethereum wallet will need to be connected to your new account on the desired platform, and after the corresponding verification processes you will be able to start depositing tokens on the pool of your choice. While it is never a difficult procedure to carry out, it is important to keep an eye on the returns, transaction fees, and exchange rates.