- What is a Liquidity Pool?
- What are the various components of a Liquidity Pool?
- What are the benefits and limitations of Liquidity Pool?
Decentralized Finance (DeFi), since its inception, has changed how people have dealt with their assets in the crypto markets. It was only after the introduction of DeFi; a user could understand what having actual custody of his assets means. I suggest you read our DeFi Guide for more information on this.
For years, we have kept our crypto assets with one of the Centralized Exchanges (CEX) such as Binance, Coinbase, FTX, etc. Although they are a good option for liquidity of funds, they become a nightmare when considering the security risks they expose us. A centralized exchange keeps custody of its user’s funds, which means that we may lose all our funds if there is a security breach on the platform.
DeFi simply saves us from this risk exposure. But what made the DeFi ecosystem possible?
It is called Liquidity Pool.
Liquidity pool works as a backbone of any DeFi platform, be it a Decentralized Exchange (DEX) such as Uniswap or Sushiswap; a lending platform such as Maker, Compound, or AAVE; or a synthetic asset platform such as Synthetix, Mirror Protocol, etc. The possibilities of what we can build with this ecosystem are endless.
So, let us understand what a Liquidity Pool is and how it fuels a DeFi platform.
What are Liquidity Pools?
A liquidity pool is a collection of funds locked in a smart contract on a DeFi platform where anyone can deposit their assets and receive rewards in exchange for providing liquidity to the platform. Let us understand this with the help of an example of a Decentralised Exchange (DEX), i.e., Uniswap.
Anyone can provide liquidity to Uniswap by depositing funds into Uniswap’s liquidity pool. The person depositing the assets is known as a Liquidity Provider.
Further, traders use Uniswap to buy or sell crypto tokens, and in exchange for that, Uniswap charges a trading fee. Uniswap distributes this trading fee to its Liquidity Providers as a reward for providing liquidity to the platform.
Thus, a liquidity pool is the essential component of any DeFi Platform.
Now let us, deep-dive, into the components of a liquidity pool.
What are the components of a Liquidity Pool?
The various components of a liquidity pool are as follows:
1. Liquidity Provider
A liquidity provider is a person who deposits his assets to a particular liquidity pool to provide liquidity to the platform. For example, a person can become a liquidity provider on Uniswap (a Decentralized Exchange (DEX)) and deposit his assets into Uniswap’s liquidity Pool.
The exchange generally issues a derivative token as a receipt of funds deposited by you. On Uniswap, these tokens are known as LP Tokens (Liquidity Provider Tokens). These LP tokens can either be burnt to withdraw liquidity from the platform or traded as is in the open market.
The term liquidity provider is a generic term and can be used differently on a different platform. For example, a lending platform would call them lenders.
Further, the type of rewards received by a liquidity provider is also different on different platforms. For example, on a DEX, a Liquidity provider would receive a share in the trading fee. However, on a lending platform, they would receive a share of the interest received from the borrowers.
The next component is the pool itself.
2. A Pool of Funds
A liquidity pool is a collection of assets where a liquidity provider can deposit his assets to be used by the platform. The structure of a liquidity pool can be different on different platforms. For example:
- A lending platform uses a single asset pool where a pool consists of one asset only.
- A DEX generally uses a dual asset pool, making it a complete market for a particular pair of assets, such as BTC/USDT, ETH/DAI, etc.
Some platforms use pools of even up to 8 assets. Thus, the structure of a pool is something that is decided by the platform itself.
Let us have an idea of how some of these platforms utilize their respective pools.
3. Type of platforms using liquidity pools
Although many different decentralized platforms use liquidity pools to provide liquidity to the protocol, these can be broadly categorized as follows:
Lending Platforms – (Single asset liquidity pool)
Lending platforms are a simple decentralized lending and borrowing market. They use a single asset liquidity pool. In the case of Single asset liquidity pools, a pool consists of one asset only.
As you can see in the above image, Compound has a DAI token liquidity pool. Anyone who wants to lend his DAI tokens can deposit his tokens through the protocol into the DAI pool. In this case, the lender would not communicate with the borrower, but this transaction will happen between the lender and the smart contract.
The lender will deposit his DAI tokens and would receive cTokens which in this case would be cDAI. cTokens can be understood as a receipt of DAI tokens deposited by the lender. In case the lender deposits ETH, he would receive cETH.
cTokens are a form of derivatives that derive their value from the base asset deposited by the lender. The value of these cTokens increases over time as it accumulates the amount of interest.
From the borrower’s perspective, a borrower would deposit collateral to receive a cToken and receive a loan against it. As you can see in the above image, the borrower would deposit ETH as collateral and receive DAI as a loan and cETH. In the case of the borrower also, the transaction is between the borrower and the smart contract.
Now, let us understand the structure of a dual asset liquidity pool.
Decentralized Exchange (DEX) – (Dual Asset Liquidity Pool)
As discussed above also, Uniswap is one of the Decentralised Exchanges (DEX’s) used for buying and selling crypto tokens. As Uniswap does not have an order book like a centralized exchange, orders are fulfilled from the various liquidity pools created on the platform.
The liquidity Pool on Uniswap consists of 2 tokens. As you can see in the above image, there is an ETH/DAI pool. Uniswap’s internal algorithm called Automated Market Makers decides the ratio at which both tokens would be deposited into the pool.
|How Automated Market Maker Works?
Basis Uniswap’s AMM price of an asset is determined based on the token supply in the respective liquidity pool. For example, in an ETH/DAI pool, there are 20 ETH and 60,000 DAI. Price of ETH = 60,000/20 = 3,000 DAI. Therefore, the value of the total ETH in the pool is $60,000, and the total DAI in the pool is also worth $60,000.
AMM algorithm ensures and adjusts prices of assets in such a way that this ratio of the value of assets is always 1:1.
For example, suppose basis Automated Market Maker (AMM) price of 1 ETH = 3,000 DAI. Then a liquidity provider will have to deposit his tokens in this ratio only, i.e., if he wants to deposit 5 ETH, he would have to deposit 15,000 DAI along with it. Every liquidity pool on Uniswap acts as a separate market for that particular pair.
In exchange for providing liquidity, Uniswap would give LP Tokens (Liquidity Provider Tokens) to the Liquidity Provider. Further, these LP Tokens can also be staked to earn more rewards.
When a trader exchanges his tokens on Uniswap, he will give a fee to Uniswap, which is then distributed to the Liquidity Pool. For more information on Uniswap, you can read our Beginner’s guide to Uniswap.
Therefore, liquidity pools help these platforms operate smoothly at all times.
The most popular lending and DEX platforms are as follows:
|Lending Platforms||Decentralized Exchanges (DEXs)|
Now, let us understand how we, as HODLers, can earn some passive income through liquidity pools.
How can you earn passive income from Liquidity Pools?
As a HODLer, we can choose a particular platform and provide liquidity to it. In exchange for this, the platform will share its revenue with us. So, based on the platforms discussed above, there can be
- You can become a lender on lending platforms,
- You can become a liquidity provider on a DEX.
Moreover, in addition to sharing revenue with the liquidity providers, DeFi platforms also airdrop their in-house tokens. This is known as Liquidity Mining.
Now, let us summarise the benefits of a liquidity pool.
What are the benefits of a Liquidity Pool?
The benefits of a liquidity pool are as follows:
- Liquidity pools help a DeFi platform by providing liquidity,
- Liquidity pools help a decentralized ecosystem operate without an order book as it is in the case of centralized exchanges
- Liquidity pools are a very attractive means for HODLers to earn passive income
However, we cannot ignore the possible risk exposure of liquidity pools.
What are the Risks and Limitations of a Liquidity Pool?
Possible limitations of a liquidity pool are as follows:
- Small liquidity pools always expose traders of a DEX to a higher Slippage Tolerance.
- A liquidity provider is exposed to the risk of Impermanent Loss in case there is a substantial change in the price of the assets deposited.
I understand that liquidity pools are still in the innovation stage, yet they are so essential to the whole decentralized ecosystem. As they would evolve, platforms would be way more dependent on them.
Further, as a HODLer, they seem to be a lucrative means of earning passive income. You can try and start with Uniswap and then explore the rest of the platform. My Uniswap Guide would be helpful for this.
Please note that I am not a financial advisor, and this is not financial advice. DYOR before investing.
I hope this article would provide you a good insight into the various Liquidity Pools. Let me know the projects or concepts that you would like me to cover on CoinSutra.
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