Understanding DeFi: What Is a Liquidity Pool and How Does It Work?

  • Crypto Guru
    December 7, 2023, 12:39

Liquidity pools are the basis of modern decentralised finance (DeFi) protocols. They play a vital role in automatic market-making, DeFi borrowing and lending and various gaming projects. Thanks to them, popular decentralised blockchain applications – DApps – can function seamlessly. Liquidity pools also give crypto investors an opportunity to earn money. In this article, the analysts at Grapherex will explain what a DeFi liquidity pool is and how it works.

Liquidity Pools Explained

Liquidity means the ability of an asset to be sold or exchanged quickly and without affecting the price. It is an indicator of how easily your cryptocurrency can be converted into cash.

A liquidity pool is a set of funds locked in a specifically designed smart contract. With a liquidity pool algorithm, market stakeholders like traders and investors can buy and sell an asset no matter how high or low the price is, what time of the day it is and whether there are actual buyers or sellers. Most decentralised exchanges, called DEXes, use liquidity pools to enable trading activity.

The first project that successfully implemented a liquidity pool was the Bancor project, but the Uniswap trading platform made the pool concept hit the headlines. Another vivid example is the Binance liquidity pool, also known as the Binance Liquid Swap.

How Does a Liquidity Pool Work?

Let’s see how exactly a pool works. Some market participants – liquidity providers (LP) – put their assets (LP tokens) into the liquidity pool to ensure greater liquidity of a certain pool. They add two types of tokens of equal value to the pool to create a “market”.

For example, to become an LP for the DAI/ETH pool, you need to invest 50:50. If you want to lock $500, then you put $250 in Ether and $250 in DAI. In exchange for providing funds, you receive trading commissions from transactions that occur in the pool of your choice. This will be proportional to your investment.

Liquidity Mining

Liquidity pools are used through liquidity mining. Liquidity pools generate returns, so crypto holders lend assets to a DEX by adding their funds to the pools. After that, there is a distribution of the reward among the participants. Liquidity mining is one of the most efficient methods of distributing tokens between users, as it happens algorithmically, and tokens are received only by those users who initially added their tokens.

Liquidity mining is extremely popular among investors because it brings passive income. This means that you can profit from mining without a need to make active regular investment decisions. Long-term investors believe that holding digital assets in the pool (using a passive income strategy) is a way to mitigate trading risks.

How to Make Money on Investments in the Liquidity Pool

As we mentioned, it is possible to make money by providing liquidity to a pool. Liquidity pool providers are rewarded for their investments. The concept is similar to a bank deposit: you lock a certain number of tokens, the platform uses them and then rewards you with a percentage. All users can become market makers (MM). The rewards are predetermined by the protocol; for example, Uniswap v2 charges traders a 0.3% transaction fee that goes directly to LPs.

Remember that there are certain risks associated with the pools. The risks of providing liquidity include bugs in smart contracts, high slippages due to low liquidity, frontrunning transactions, and impermanent loss. However, these risks are not as high as those of regular trading or investing.