Liquidity Pools Explained

A lot goes on in the crypto space and anyone who wishes to participate must understand its terms. Among the most central ones, there are liquidity pools, market caps, staking, and more. Here, we are exploring the case of liquidity pools, a major component which powers Decentralized Finance.

But what exactly are liquidity pools, and how do they affect DeFi services? If these are your thoughts, you’re in luck. Shortly, you’ll learn the basics of this essential aspect of cryptos. We would also compare it to another unique concept, staking. That’s a two-for-one special right there. Without further ado, let's get down to brass tacks!

What are liquidity pools in crypto, and why are they important?

Crypto liquidity pools are collections of coins locked in smart contracts. These funds are then used to facilitate trades, loans, and other transactions on DeFi platforms.

In traditional finance, big players such as banks provide liquidity (money, basically), but in DeFi it's a community effort. The crypto pools are crowdsourced, allowing anyone to contribute and earn rewards. 

Liquidity pools are essential for several reasons. Let's take a look:

• Getting smooth transactions. Trades will be received timely and efficiently with little to no price slippage.
• The larger the pool, the less price slippage traders experience. Therefore, a liquidity pool helps stabilize asset prices on Decentralized exchanges.
• For DeFi users, it's a form of passive income generation. People who provide liquidity are rewarded for trades that occur in the pool. 
• Liquidity pools support several financial activities beyond simple token swaps. Examples include automated market makers (AMMs) and yield farming.

How do liquidity pools work 

Imagine a marketplace filled with many traders and people who have come to purchase goods or services. Rather than having individual stalls, every trader comes together under one roof to sell their produce. This community effort makes it easier for buyers to get what they want. The one roof, in context, stands as the cryptocurrency liquidity pool.

Let's go further down this rabbit hole.

So far, we’ve come to understand that the asset in the pool is locked in a smart contract. While in the smart contract, these assets can be traded/exchanged. How does this work? Let's look at the fruit example: You have oranges, but what you need are apples.

To get your desired apples, you need to find someone willing to swap oranges for apples. So, you head to where all the traders are gathered. There, you will find plenty of apples and oranges available.

When you add your oranges to the market's pool, you're not just trading but also becoming a part of the market. Therefore, you will be rewarded with incentives. Anyone who comes after to trade will have to pay a small fee. The accumulated fees will be shared amongst everyone who contributed to the pool. It's like being a shareholder and earning a tiny commission when someone conducts fruit business under one roof.

The more people contribute, the larger the pool grows. This keeps the market stable and ensures there’s always enough of each token (or fruit) available.

Types of liquidity pools

Liquidity pools come in different forms, each serving a unique purpose inside the DeFi ecosystem. Here, we have grouped them into five types. As a trader or investor, you should understand these five. It will help you select the most appropriate strategies and risk profiles.

Single-Asset Pools

There’s a hint in the name. You can tell that the pool only accepts a specific type of crypto tokens. They offer low-risk returns for Liquidity Providers (LPs), which is ideal for assets that require a reliable source of liquidity. An example is stablecoins, such as a Tether pool with USDT tokens. 

Multi-Asset Pools

For this type of pool, LPs are required to deposit pairs of assets. The pool structure is perfect for DEXs and DeFi apps, as it was designed to enable token swaps. It allows for a smooth trading and lending process. The fees generated from each within the pool are shared amongst the LPs.

Staking Pools

Anyone involved in the crypto industry has probably come across the term proof-of-stake (PoS). In short, it is a consensus mechanism used to verify new crypto transactions. LPs pool their assets to participate in PoS validations so the blockchain functions properly. This way, the network is secured, and they are rewarded.

Hybrid Pools

If the features of a single-asset pool and a multiple-asset pool had a baby, it would be the hybrid pool. This pool combines different models to create a dynamic and adaptable liquidity solution. In a hybrid pool, you will experience better liquidity provisions and reduced slippage. They are ideal for complex DeFi applications.

Incentivized Pools

Aside from the rewards LPs are entitled to, incentivized pools add special rewards. It could come as platform-specific tokens or an increased percentage of entitled rewards. These pools often partner with DeFi projects, boosting their ecosystems. The structure attracts more LPs, reducing slippage and improving market efficiency. 

How to profit from liquidity pools 

Liquidity pools offer several ways for you to make extra cash. To profit from these pools, consider these strategies: 

• Provide Liquidity: Liquidity providers earn a portion of trading fees. This return is proportional to your share in the pool. The more trades, the higher the fees earned.
• Yield Farming: This is a form of incentivized pool. The platforms offer additional rewards and interest for lending assets to the pool.
• Arbitrage Trading: Take advantage of price differences between exchanges. You can take loans from the pool to execute the arbitrage trade, potentially earning a profit.
• Liquidity Mining: By providing liquidity to new/low-liquidity pools, you help them establish a market presence. This would result in an increased number of users and rewards.
• Reinvestment: The fees or rewards earned can be reinvested into other pools. This not only minimizes risks but also maximizes returns. It also becomes a passive income stream.

What are the risks of liquidity pools? 

As with any cryptocurrency investment, there are downsides. Decentralized finance operations, which include liquidity pools, are notable for being high-risk. Here are major things you need to take into account if you are considering joining a pool.

Impermanent loss

It is the most common type of risk for LPs. This loss occurs when the price level of the underlying asset in the pool fluctuates. For example, say ETH is the pool's underlying asset, and the market price has declined by 5%. When this happens, the pool will witness a decline in value. This will, in turn, affect ROI and the interest shared.

Note that impermanent loss can go both ways: increase or decrease. The only way to reduce this volatile risk is by providing liquidity for stablecoins.

Flawed Smart Contracts 

The smart contract houses the pool meaning that a breach would be disastrous as the pool could be drained entirely. 

Once a hacker has a hold of the smart contract, they determine the cash inflow and outflow. This is what happened to the Balancer protocol in 2020. The attack involved multiple transactions, including manipulating token prices and utilizing flash loans. The hackers got away with $238K worth of crypto by taking several flash loans.

Only invest in audited liquidity pools to minimize the risk of vulnerable smart contracts and ensure a safer investment experience.

Liquidity pools vs Staking

These two are popular strategies crypto investors use to earn a passive income on their holdings. While they have similar processes, they serve different purposes. Let's compare and contrast between liquidity pools and staking.

It falls to you to choose one of the two based on individual risk tolerance and investment objectives. Consider these factors to make informed decisions.

Conclusion: a few final words

Seeing how central liquidity pools are to DeFi, it’s no surprise that it's a hot topic amongst cryptoheads. They represent the backbone of the decentralized ecosystem and are crucial for its good functioning.

If you decide to contribute to any pool, be sure to consider the related risks balanced with your objectives before choosing to put your money there. But by doing so, you’ll be contributing to the well-being of DeFi.