What Are Liquidity Pools? 

A liquidity pool is a collection of crypto assets locked in a smart contract. It is so named because these assets are pooled together to provide liquidity to a trading pair. In some ways, you can compare it to the cash locked in a bank vault. However, unlike centralized banks, anyone can provide liquidity to a liquidity pool. 

The first liquidity pools were probably started in 2017 by Bancor, a decentralized platform that launched Automated Market Makers (AMMs). Since then, they have become more popular and are now widely used on popular decentralized exchanges like Uniswap, Pancakeswap, Curve, and many others. 

How Do They Work? 

Generally, cryptocurrencies eliminate the need for intermediaries and allow direct contact between buyers and sellers. Liquidity pools go a step further by eliminating the need for peer-to-peer contact. Therefore, buyers do not need to search for sellers before fulfilling their orders. They simply dip their hands into the liquidity pool (so to speak) and fish out their desired assets. 

Most liquidity pools consist of two tokens mixed in equal proportions. Anyone who adds tokens to this mix is known as a Liquidity Provider (LP) and is given LP tokens as proof that he has a share in the pool. Whenever someone trades off the liquidity pool, he pays a fee. This fee is then distributed among all the liquidity providers according to their investment proportion. Thus, liquidity providers earn passive income as an incentive. This method of earning is known as liquidity mining. 

LP tokens may also be used in other ways. For example, many can be staked to earn even more tokens. You can also use them for governance purposes or as NFTs. In some cases, you can even trade them for other crypto assets. 

What Are Their Use Cases? 

Automated Market Makers 

This is the most common use of liquidity pools. It replaces the order-matching system of traditional exchanges and is the backbone of most DeFi operations. AMMs operate according to a price algorithm which may be simple or complex depending on the platform. Thus an AMM is truly decentralized because the price cannot be influenced by external factors, which is more than we can say for centralized exchanges. 

Governance 

Liquidity pools also allow providers to vote on project proposals. In some cases, this comes directly from the number of LP tokens held. The higher the number, the greater the voting power. In other cases, liquidity providers are rewarded with governance tokens. They can then stake these tokens to earn a right to vote on community proposals. Also, if the number of tokens required for voting is very high, participants can pool their funds together to rally behind a common cause. 

Yield Farming 

Yield farming is usually confused with liquidity mining. But there is a difference. Liquidity mining refers to the process of earning income by being a liquidity provider. The income from liquidity mining comes from the fees traders pay to use the pool. 

On the other hand, even though yield farming also involves providing liquidity to liquidity pools, it goes much further than that. The assets deposited in the pool are further used to generate yield through staking, lending, and other ways. Therefore, yield farming usually generates more returns than direct staking and liquidity mining. 

Learn more about yield farming here.

DeFi Insurance 

Many DeFi insurance protocols use liquidity pools to implement various smart contract protection packages. The liquidity providers act as underwriters and risk their assets in the process. They are then rewarded with a cut of the premium that insurance buyers pay. Depending on the protocol, liquidity providers may also act as claim assessors, determining whether or not insurance claims are legit. 

Do They Come With Risks? 

Yes, they do. Some of the risks are: 

Impermanent Loss 

Impermanent loss is the loss you incur when the prices of your deposited assets change relative to each other after you put them in a liquidity pool. It is an ever-present danger regardless of which assets you deposit. Sometimes the loss incurred may be negligible; sometimes, it may be huge enough to sway your profit margin. 

You will understand better with an example. Let’s say you deposited $BNB and $NFTART in a liquidity pool when they were $300 and $0.01, respectively. If you had $300 to spare, you would buy $150 of each token (0.5 $BNB and 15,000 $NFTART) and get a fixed amount of LP tokens. These LP tokens represent a 50:50 ratio of both tokens. 

But what if $BNB’s price declines to $150 and $NFTART is now $0.012? The value of your LP holdings is now {(0.5 $BNB X 150) + (15,000 $NFTART X 0.012)}. In other words, your LP holdings are now valued at $255. You have suffered a loss of $45 from your initial $300 capital. The loss is called impermanent because it is only permanent when you remove your holdings from the pool. As long as your holdings are still in the pool, the prices may still balance out. 

If you want to know more about impermanent loss, please check this article. 

Smart Contract Risks 

Because liquidity pools are used extensively in decentralized finance, they are subject to hacks, scams, and other exploits. Funds locked in a liquidity pool are only as secure as the platform itself. Therefore, you should be wary of the pool in which you deposit your funds. If the pool is exploited, your money may be gone forever. 

Red flags usually include developers that are not forthright, unreasonably high yields and smart contract codes that are not verified, among others. Make sure to do your own research and weigh all options well before jumping in. 

Pros And Cons Of Liquidity Pools 

Pros 

● Liquidity pools are very simple to create. This makes it possible for anyone to be in control of their wealth. 

● It provides a better price balance than most centralized order books 

● It gives upcoming tokens a fighting chance. They no longer need to be listed on the big exchanges to achieve exposure. 

● The security information of liquidity pools is usually publicly accessible. Therefore, anyone can check how much funds are left in the pool and how secure it is.

Cons 

● There is the lurking danger of the pool being controlled by a wealthy minority. This goes against the concept of decentralization. 

● Liquidity pools come with their own risk and funds can be lost due to impermanent loss, scams, and hacks

Conclusion 

Decentralized finance is one of the greatest innovations of the 21st century, and liquidity pools are at the heart of this innovation. They allow you to be in control of your financial wealth and have seen various applications because of their simple concept. However, if you are thinking of starting or joining one, don’t just jump in. Consider the risks and benefits discussed in this article and make your decision wisely.

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