As a result of decentralised finance, there has been an explosion of on-chain activity (DeFi). DEX volumes may greatly compete with the volumes on licenced exchanges. By the end of 2020, nearly 15 billion dollars worth of property were locked up in DeFi technology. New items are continually entering the ecosystem.
What, then, allows all of this expansion? With all of these products, are liquidity pools a key component?
What is a liquidity pool?
A smart contract’s liquidity pool is a collection of funds that have been locked aside for consumption in the future. As we’ll see in greater detail later, liquidity pools allow for decentralised trading and lending.
Liquidity pools are important to the operation of numerous decentralised exchanges (DEXs). Users called liquidity providers (LP) give an equal number of two tokens in a pool to construct a market. They obtain a percentage of the trading fees created by the transactions in their pool as compensation for their participation.
Since anyone may now be a liquidity provider through AMMs, the stock market has become more accessible to a larger spectrum of investors.
Bancor was the first to deploy liquidity pools, but the idea gained popularity after being implemented in Uniswap. Some other prominent exchanges that leverage liquidity pools on Ethereum include SushiSwap, Curve, and Balancer. These places’ liquidity pools employ ERC-20 funds.
Any seasoned trader in conventional or crypto markets can warn you about the possible hazards of joining a market with minimal liquidity. Whether it’s a micro-cap cryptocurrency or a penny stock, slippage will be a problem when wanting to join or abandon any contract.
The discrepancy between the expected and actual price of a transaction is known as “slippage.” Slippage is most prevalent during moments of heightened volatility and may also occur when a big transaction is performed but there isn’t enough activity at the desired price to sustain the bid-ask spread.
During periods of high volatility or low activity, the market order price employed in a typical order book approach is set by the bid-ask spread for a single trading pair. In other words, it’s the price in the middle between what sellers are willing to accept for the item and what buyers are willing to pay for it.
This might cause more slippage and a higher execution price than the initial market order price, depending on a particular asset’s bid-ask spread at any given time.
To address the problem of illiquid markets, liquidity pools compel users to offer crypto liquidity in exchange for a portion of trading fees.
Using liquidity pool protocols like Bancor or Uniswap reduces the requirement for matching buyers and sellers. Liquidity given by users and traded using smart contracts implies that token holders may rapidly swap their holdings.
How do liquidity pools function?
Liquidity pools make reasonable sense if you get through the jargon and verbiage. Crypto is vital for DeFi to have any form of economic activity. And that crypto has to be somehow delivered, which is precisely what liquidity pools are designed to offer.
Smart contracts called “liquidity pools” are used to store crypto tokens issued by the platform’s users. Since they are self-executing, no third party is essential to make them operate. Other kinds of code, such as automated market makers (AMMs), are utilised to maintain liquidity pools in balance via mathematical techniques.
Dangers of liquidity pools
While the advantages are clearly a draw, being a liquidity provider comes with a distinct set of perils. Changing supply and demand may result in a “permanent loss” when the value of a company’s assets is lowered or enhanced.
If the asset’s value has declined sufficiently, trading fees may not be sufficient to cover losses. Do not be deceived by the phrase “permanent” either. Once the liquidity source withdraws its position, all losses become permanent.
Liquidity pools, especially smaller ones with less liquidity, have typically been targeted by market manipulation activities. In order to flood markets with massive orders and deplete smart contracts of cash, so-called “hackers” utilise strategies such as flash lending.
As a consequence, customers should stay clear of smaller providers or pools with less liquidity, as they are more susceptible to such attacks.
Finally, like with any blockchain-based application, the risk of smart contracts should be taken into consideration. Platforms that have been carefully evaluated and have been demonstrated over time are generally more trustworthy bets than applications created on fresh or untested technology.
The introduction of liquidity pools has been the greatest development in the crypto industry in recent years. As a consequence, the current DeFi technology stack is better suited for daily usage. Liquidity pooling may conceivably allow a vast variety of use cases in the DeFi ecosystem, including decentralised commerce, yield farming, lending, and many more.
The liquidity pool may increase accessibility and output potential, as well as establish new channels in DeFi applications. However, there are several downsides to employing smart contracts, including the risk of temporary loss and an over-reliance on them. In the long term, liquidity pooling will shape the DeFi ecosystem with new and better solutions.