The DeFi ecosystem heavily relies on liquidity pools, which serve as a foundational technology for various functions such as automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, and blockchain gaming. Despite the simplicity of the concept, the potential of a pile of funds thrown together in a permissionless environment where anyone can add liquidity is enormous.
The increasing adoption of DeFi has led to an explosion of on-chain activity, and as of December 2020, almost 15 billion dollars of value are locked in DeFi protocols. The rapid expansion of the ecosystem is due in large part to the liquidity pool’s essential role in various DeFi products.
In this article, we will delve deeper into how DeFi has evolved the idea of liquidity pools.
What is a Liquidity Pool?
A liquidity pool is a digital mechanism for holding a collection of funds in a smart contract. It is a fundamental technology that enables decentralized trading and lending, among other functions. The idea behind a liquidity pool is relatively simple; users contribute equal values of two different tokens to a smart contract to create a market. Liquidity providers (LP) are rewarded with trading fees proportional to their share of the total liquidity in the pool. As a result, liquidity pools have significantly enhanced the accessibility of market-making activities.
Liquidity pools have been instrumental in the rapid growth of the DeFi ecosystem. Decentralized finance is still a new field, and liquidity pools have opened up several new avenues of financial activity. They have facilitated a wide range of innovative projects, such as yield farming, synthetic assets, on-chain insurance, and blockchain gaming. They have also made trading and lending more efficient, less costly, and less dependent on centralized intermediaries. As a result, they have attracted a significant amount of investment and attention from both individual and institutional investors.
To further understand how Liquidity Pools work, we need to first take a closer look at how Centralized Exchanges (CEX) work.
How do CEXes Operate?
The matching engine, along with the order book, is a fundamental component of any centralized exchange (CEX) as it enables efficient exchange and supports complex financial markets. However, when it comes to executing trades on-chain in DeFi trading, the order book poses a significant challenge due to the gas fees incurred with each interaction. This results in high costs for market makers and limits the blockchain’s throughput capacity. On-chain order book exchanges are impractical on most blockchains, such as Ethereum, as they cannot handle the high transaction volumes of billions of dollars daily.
As a result, assets on other networks generally can not be traded without the help of cross-chain bridges and/or scalability solutions such as rollups. Overall, however, the throughput of the network oftentimes is unable to support an on-chain order book exchange.
How do Liquidity Pools Work?
Automated market makers (AMMs) have revolutionized on-chain trading by allowing for decentralized trading without the need for an order book. In contrast to order book exchanges, where buyers and sellers are connected through the order book, trading on an AMM is peer-to-contract. This is made possible through the use of liquidity pools, which are collections of funds deposited by liquidity providers into a smart contract. Trades on an AMM are executed against the liquidity in the pool, rather than against a specific counterparty. Thus, for a buyer to buy, there does not need to be a seller at that particular moment, only sufficient liquidity in the pool.
In AMMs, pricing is determined by algorithms based on the trades that occur within the pool. Liquidity providers earn trading fees from the trades that occur in their pool, proportional to their share of the total liquidity. Although anyone can become a liquidity provider, they are not considered a counterparty in the same sense as in order book exchanges, as they are not directly interacting with the buyer or seller. Instead, the smart contract that governs the pool manages the transaction.
It should be noted that the liquidity that allows AMMs to function must come from somewhere. However, unlike in the order book model, liquidity providers are not directly connected to the buyers and sellers. Instead, they are interacting with the smart contract that governs the liquidity pool.
As a result of being built on blockchain technology, AMMs are also inherently decentralized, allowing for more transparency, security, and control over assets.
What are Liquidity Pools used for?
One of the primary purposes of liquidity pools would be yield farming or liquidity mining, which are one of the successful approaches for distributing new tokens to appropriate parties in crypto projects.
The process involves having users add funds to liquidity pools, which serve as the foundation of automated yield-generating platforms like yearn, to generate yield. Tokens are algorithmically distributed to users who contribute their tokens to a liquidity pool thereafter, and newly minted tokens are then proportionally distributed based on each user’s share of the pool.
Moreover, tokens from other liquidity pools, namely pool tokens, can also be used. These pool tokens can be utilized to deposit into another pool and earn returns. Additionally, governance, insurance against smart contract risk, tranching, and minting synthetic assets on the blockchain are some emerging use cases that are powered by liquidity pools. The latter involves adding collateral to a liquidity pool, connecting it to a trusted oracle, and creating a synthetic token that is pegged to a desired asset. As this technology continues to develop, there are likely many more use cases for liquidity pools that have yet to be discovered and developed by DeFi developers.
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