What Are Liquidity Pools? The Funds That Keep DeFi Running

Learn more about Consensus 2024, CoinDesk’s longest-running and most influential event that brings together all sides of crypto, blockchain and Web3. Alex leans on his formal educational background (BSBA with a Major in Finance from the University of Florida) and his on-the-ground experiences with cryptocurrency starting in 2012. Alex works with cryptocurrency and blockchain-based companies on content strategy and business development. He privately consults entrepreneurs and venture capitalists on movements within the cryptocurrency industry. It’s easy to get tripped up in all the funky what is a white label mobile app definition and examples protocols and token names. It’s important to keep in mind that DeFi is only a few years old, and things break.

What is a liquidity pool?

And in many cases, these funds are either non-recoverable or only partially recoverable. Some projects also give liquidity providers liquidity tokens, which can be staked separately for yields paid in that native token. This is a bit confusing, but the difference is more than just semantics. We also talked about a liquidity pool being a combination of at least two tokens locked in a smart contract. Well, it’s pretty lucrative (and risky) and many yield seekers jump into liquidity pools in search of monetary gain. Others with a more technological bent view their participation in liquidity pools as a means to uphold a decentralized project.

When DEXs were first invented, they encountered liquidity problems as they tried to mimic traditional market makers. With the automated, algorithmic trading provided by crypto liquidity pools, investors can have their trades executed right away with minimal slippage if liquidity is sufficient. Buyers and sellers are matched immediately, eliminating spreads since there is no order book.

What are the different types of cryptocurrencies? Understanding token types

Users of DeFi protocols “lock” crypto assets into these contracts, called liquidity pools, so others can use them. Liquidity pools, in essence, are pools of tokens that are locked in a smart contract. They are used to facilitate trading by providing liquidity and are extensively used by some of the decentralized exchanges a.k.a DEXes.

This can lead to situations where, despite earning fees, you might have been better off just holding the tokens in the open market. For instance, Yearn Finance offers a yield farming and aggregation tool with a development team that’s always working on new strategies to earn users higher yields. The platform has more than 30 Curve pools where investors can deposit five different cryptocurrencies into smart contracts.

Protocols often denominate the APR in the number of tokens (often the native token of the platform, like FOX) rather than a U.S. Your actual dollar APR can be more or less depending on the value of the token. In other words, in the face of highly efficient exchanges, an exchange without liquidity sucks– and DEX developers planned for this. Traditionally, you would have to acquire the equivalent value of assets and then manually put them into the pool. This is mainly seen on networks with slow throughput and pools with low liquidity (due to slippage). Balances various assets by using algorithms to dynamically alter pool settings.

By providing liquidity to DeFi platforms, you can earn interest and grow your crypto portfolio. In a bear market, on the other hand, the risk of impermanent loss could be far greater due to the market downturn. This is only true, however, when the fall in price of one c++ hello world program asset is greater than the pair’s appreciation. Impermanent loss is the most common type of risk for liquidity providers. At the time of writing, there is estimated to be over $45 billion of value locked in liquidity pools. Liquidity pools are crucial for peer-to-peer trading in decentralized finance (DeFi).

1. Thanks to a software innovation called automated market maker (AMM) algorithms, liquidity pools maintain fair market value for all their tokens automatically.
2. They are used to facilitate trading by providing liquidity and are extensively used by some of the decentralized exchanges a.k.a DEXes.
3. In other cases, many DEX upstarts don’t have a centralized company established or an office you can call if things go awry.

Keep the product of the two token quantities constant and modify the pricing when trades cause the ratio to change. For a sizable portion of people on the planet, it’s not easy to obtain basic financial tools. Bank accounts, loans, insurance, and similar financial products may not be accessible for various reasons. But the model has run into a similar problem—investors who just want to cash out the token and leave for other opportunities, diminishing the confidence in the protocol’s sustainability. On the other hand, illiquidity is comparable to having only one cashier with a long line of customers.

What Are Liquidity Pools?

Some popular options include Uniswap, SushiSwap, Curve, and Balancer. Finding the platform that’s right for you will depend on various factors like what assets you’re looking for, what kind of rewards you can receive, and which user interface you find most appealing. Some useful tools include CoinMarketCap and Pools, where users can investigate different liquidity pools. Liquidity pools make it possible to trade crypto without the need for a central intermediary maintaining an order book. This allows traders to swap tokens directly from their wallets, reducing counterparty risk and exposure to certain risks that centralized exchanges may face, like employee theft. These are pools of funds that provide liquidity for different DeFi activities.

Some of the 2nd layer scaling projects like Loopring look promising, but even they are still dependant on market makers and they can face liquidity issues. On top of that, if a user wants to make only a single trade they would have to software development articles for dummies move their funds in and out of the 2nd layer which adds 2 extra steps to their process. Before we explain how liquidity pools work under the hood and what automated market making is, let’s try to understand why we even need them in the first place. Liquidity pools operate in a highly competitive environment where competitors constantly chase higher yields. According to Nansen, more than 40% of yield farmers providing liquidity to a pool on launch day exit within 24 hours. And by the third day, nearly three-quarters of initial investors are gone chasing other yields.