How do trades work in traditional finance?
Before we get into how crypto liquidity pools work, we must review how traditional financial markets match buyers with sellers.
Have you ever wondered why you can instantaneously make a trade on exchanges? Every trade requires some entity on the other side, yet there always seems to be one available. Much of the time, this entity is a market maker. Centralized markets heavily rely on entities known as market makers to ensure traders will always get their orders filled.
Market makers hold massive positions in assets like stocks that they make available to traders. The price market makers are willing to buy assets for is known as the bid, whereas the price they’re ready to sell them for is the ask. To ensure a profit, market makers build in a slight price discrepancy between the bid-ask price (or the bid-ask spread).
Since market makers have a vast supply of assets, they help trading platforms match buyers with sellers promptly. The liquidity that market makers provide ensures traders always resolve their trades at the agreed-upon price. In contrast, illiquid markets frequently suffer from price slippage due to a lack of readily available securities. “Slippage” refers to a significant change between the quoted and actual price of an asset. By the time a trade closes on an illiquid market, chances are the price will deviate from what traders expected to buy or sell their investments.
In traditional finance, market making is a closed system only open to high net-worth individuals, firms, and corporations. Citadel Securities and Virtu Financial are a few of the most prominent market makers in the U.S. stock market (at the time of writing).
What is a liquidity pool in crypto?
A liquidity pool (crypto) serves the same purpose as market makers, but they do away with the centralized hierarchy of traditional finance. Instead of relying on third parties like Citadel, decentralized exchanges (DEXs) allow anyone to “pool” their crypto onto a platform to facilitate trades.
Liquidity pools rely entirely on code-based programs known as smart contracts. Blockchains like Ethereum use smart contracts to execute commands without a third party. Once the conditions of a smart contract are met, it should fulfill its program automatically. For example, if a smart contract is set to release your collateral when you’ve paid off a crypto loan, it’ll do so after it detects the final interest payment.
These large pools of funds supply DEXs with the necessary crypto liquidity to allow other users to swap tokens without relying on external firms or large investors. People with a private crypto wallet and cryptocurrency can add their tokens to these protocols. In exchange for this, they’re rewarded a share of trading fees. Web3 developers hope this new decentralized system will democratize the trading experience for average investors.
How do liquidity pools work?
Liquidity pools run on smart contract code. While there are many algorithms a DEX can use to create its liquidity pools, the most prominent is the “x*y = k” formula. In this algorithm, “x” and “y” refer to the two tokens in the liquidity pool, while “k” is a constant value. Since “k” must stay consistent, the DEX will constantly adjust the distribution of “x” and “y” tokens, so they remain evenly split. DEXs like Uniswap, SushiSwap, and PancakeSwap use this algorithm to balance the tokens in their liquidity pools.
Besides smart contract algorithms, liquidity pools rely on arbitrage traders to ensure a digital asset’s quoted price is accurate. Arbitrage is a strategy where traders capitalize on a slight price discrepancy on a token between two exchanges. If arbitrage traders notice a token’s price on one DEX is slightly lower than on a centralized exchange (CEX), they’ll likely buy the asset on the DEX and quickly sell it on the CEX.
But what’s the point of arbitrage across liquidity pools? This trading strategy will exert the necessary buying or selling pressure on the deposited tokens, which should bring the tokens in a liquidity pool into balance.
Along with arbitrage and algorithms, liquidity providers (LPs) are crucial for liquidity pools. LPs are people who deposit their crypto into a liquidity pool. Since LPs supply the tradable assets on a DEX, they’re equivalent to market makers in traditional financial markets. Remember, anyone can provide their crypto to a DEX’s liquidity pool if they have a private crypto wallet and the necessary tokens.
What are liquidity pool tokens?
One may wonder why anyone voluntarily locks their crypto in a DEX’s liquidity pool. Besides supporting decentralized crypto trading, what benefits can LPs expect?
On most DEXs, LPs get a slice of the overall trading fees for whatever token pair they contribute. For example, Uniswap has a flat 0.3% trading fee constantly distributed among all LPs. The number of tokens you contribute to a liquidity pool will dictate the token rewards you get for every swap.
LPs can also receive bonus token rewards depending on what DEX they’re on. Most DEXs have governance tokens built into their rewards structure. In addition to acting as bonus incentives, these governance tokens give holders a vote in proposed upgrades to a DEX. A few prominent DEX-issued tokens include Uniswap’s UNI, PancakeSwap’s CAKE, and SushiSwap’s SUSHI.
How have liquidity pools revolutionized finance?
Liquidity pools offer a novel solution to providing secure crypto liquidity in DeFi (decentralized finance). Autonomous smart contracts, open-source code, and easy access to average investors can chip away at the power and influence of centralized market makers. Liquidity pools provide crypto investors with a simple, trustless way to make trades or deposit funds for passive rewards.
Although the total value locked (TVL) in liquidity pools has grown since Uniswap’s launch in 2018, remember it’s still in its early development phase. CEXs like Binance still offer far greater liquidity to crypto traders.
However, if the DeFi sector grows, liquidity pools will provide a new market-making model. It’s not just DeFi-specific tokens that can be available for trading. In the future, more DEXs might offer security tokens representing synthetic stocks, ETFs (exchange-traded funds), and precious metals. The more liquidity pools and DEXs catch on, the less influence centralized markets may have.
Safety considerations with liquidity pools
As exciting as liquidity pools are, there are risks associated with depositing funds in these smart contracts. People must review common LP risks to manage their crypto portfolios.
A significant issue with becoming an LP is a phenomenon known as impermanent loss. Remember that liquidity pools are constantly adjusting to maintain an equal proportion of tokens. As the prices of digital assets change, so will the balance of your crypto in the liquidity pool. Impermanent loss refers to the “loss” of more substantial gains than simply holding a cryptocurrency.
For instance, you deposit 1 ETH and 2,000 USDT in an Uniswap ETH/USDT pool. Uniswap’s liquidity pools require that LPs deposit a 50/50 split of tokens. So, at this time, 1 ETH equals 2,000 USDT.
Let’s also assume there are 50 ETH and 100,000 USDT in this pool when you supply liquidity. This means you own a 2% share in the liquidity pool, and the constant “k” value is $200,000.
Should the price of ETH skyrocket to 4,000 USDT, the total ETH balance in this pool would go down to 25 ETH as arbitrage traders bring the liquidity pool into balance. If you withdraw your tokens now, you’d have half of the ETH you initially deposited. While your 0.5 ETH is still 2,000 USDT, it would have been worth double had you just held the 1 ETH.
Note: This example doesn’t factor in all the token rewards you would be earning during this time. Also, this example assumes nobody else is adding liquidity to your pool.
Besides the risk of impermanent loss, new LPs must remember that DeFi is an unregulated space. There are no insurance protections on DEXs, so there’s a minute possibility that you may lose all your funds if there’s a hack or bug in the smart contract code.
Currently, many experts recommend sticking with the most high-profile DEXs and prioritizing dApps (decentralized applications) with high TVL and a long track record. A few of the most prominent DEXs include (at the time of writing):
- Uniswap
- Curve Finance
- PancakeSwap
- Balancer
Wrapping up
Liquidity pools are a giant leap forward in the DeFi ecosystem. Should liquidity pools gain greater prominence, they can check the influence centralized market makers have over trading platforms. Although smart contract technology is at a nascent stage, liquidity pools seem promising as a democratizing tool for global traders.
Speaking of “democratizing crypto,” at Worldcoin, we want to bring the opportunities of Web3 into the globalized economy. We aim to put a share of our crypto in the hands of every individual on the planet for free. Subscribe to our blog to know more.
