The world of finance is liquidity driven. With no funds available, financial systems are stagnant. In Decentralized Finance (or DeFi, for short) — a term that refers to financial services and products on the blockchain —, the same thing happens. DeFi activities such as lending and borrowing or token conversion rely on standalone contracts — self-executing code. Users on DeFi protocols “lock” crypto assets in these contracts, called “liquidity pools”, so that other users can use them. Liquidity pools are an innovation of the crypto industry, meaning they do not have a direct equivalent in traditional finance. In addition to providing utility to the core activities of a DeFi protocol, liquidity pools also act as a kind of hub to attract investors with an appetite for high risk and high returns.
How do liquidity pools work?
By going beyond technical language, the basic reasoning about liquidity pools is intuitive. For any economic activity to take place in DeFi, there needs to be cryptocurrencies. And these crypto assets need to be provided somehow, which is exactly why liquidity pools were created. This task is performed by order books and market makers at centralized brokerage firms (or CEXs). When someone sells token A to buy token B on a decentralized (or DEX) exchange, they rely on tokens from the A/B liquidity pool offered by other users. When they buy B tokens, there will be less B tokens in the pool and the B token price will go up. This is a basic aspect of supply and demand in the economy. Liquidity pools are standalone contracts that contain crypto tokens provided by platform users. These contracts are self-executing, that is, they do not need intermediaries to make them work. They are aided by other codes, such as automated market makers (or AMMs), which help maintain balance in liquidity pools through mathematical formulas. In 2017, Bancor pioneered the concept of AMMs. In 2018, Uniswap, now one of the biggest DEXs on the market, popularized the general concept of liquidity pools.
Why is low liquidity a problem?
Low liquidity results in high slippage — huge difference between the estimated trade price of a token and the execution price. Low liquidity results in high slippage as the token fluctuates within a pool as a consequence of a conversion or other activity causes large imbalances when there are fewer tokens locked in pools. When the pool is very liquid, traders will not experience slippage. But high slippage is not the worst case scenario if there is not enough liquidity for a specific trading pair (like ETH/COMP) across all protocols, so users will be stuck with tokens they won’t be able to sell. This is what happens a lot with scams known as “rug pulls” (or “rug pulls”) — scams in which projects disappear with investors’ money — but it can also happen naturally if the market doesn’t provide enough liquidity.
How much liquidity is there in the DeFi industry?
DeFi liquidity is generally expressed in terms of “total locked value” (or TVL), which measures the amount of cryptocurrency that is allocated to protocols. Currently, the TVL of the entire DeFi sector is $211.5 billion, according to the DeFi Llama website. TVL also helps to understand the rapid growth of DeFi: In 2020, protocols developed on Ethereum recorded a TVL of just US$1 billion.
Why provide liquidity to a pool?
For investors, providing liquidity can be profitable. Protocols incentivize liquidity providers through token rewards. This incentive structure gave rise to a cryptocurrency investment strategy known as “yield farming”, in which users move assets between different protocols to benefit from returns before they disappear. Most liquidity pools also provide liquidity supply tokens (or LPs), which are a kind of receipt that can then be exchanged for pool rewards — proportionate to the liquidity provided. In other cases, investors can stake LP tokens on other protocols to generate even more returns. However, there are risks. Liquidity pools are prone to “impermanent losses” — when the proportion of tokens in a liquidity pool (for example, a split of 50% in ETH and 50% in USDT) becomes unbalanced due to significant price changes. This may result in the loss of invested funds.
Who uses liquidity pools?
– 1inch: aggregator of DEXs and compatible with several blockchains; – Aave: decentralized lending platform; – Uniswap: DEX for the conversion of tokens developed on Ethereum.
How to add liquidity?
Generally speaking, there are two ways to provide liquidity. If you want to add funds directly to a liquidity pool, such as the ETH/USDC liquidity pool on SushiSwap, you will need to have equal amounts in ETH and USDC, which can be converted to any DEX. You also need to have an equivalent pair of tokens, as lending and most other DeFi activities are almost always bilateral — ETH is converted to USDC, DAI is borrowed in exchange for ETH, and so on. As a consequence, most protocols allow liquidity providers to allocate the equivalent value (50/50) of two cryptoassets to available pools so that a balanced pair is maintained. The Balancer protocol takes an innovative approach, allowing around eight tokens in a single liquidity pool. However, there is also a less complicated way. You can “zap” a liquidity pool — adding liquidity in a single transaction on platforms such as Zapper, which invented this concept in 2020. Go to zapper.fi and connect your wallet. Click on “pools” to see available liquidity pools and zap at will. Add liquidity to the pool using whatever assets you have. Zapper will convert them into equal amounts of the relevant pair. This saves you a few separate transactions! However, Zapper does not list all the liquidity pools in the DeFi industry, restricting your options to the largest pools.
What is the future of liquidity pools?
Liquidity pools operate in a competitive environment and attracting liquidity is a difficult task when investors are constantly looking for high returns on other platforms and taking liquidity with them. Nansen, a blockchain analytics platform, found that 42% of “yield farmers” that provide liquidity to a pool on launch day exit the pool in less than 24 hours. On the third day, 70% of the liquidity will be gone. To deal with this problem, called “mercenary capital”, OlympusDAO tested the “liquidity belonging to the protocol”. Rather than creating a pool of liquidity, the protocol allows users to sell their assets in their treasury in exchange for OHM, their native token at a discount. Users can stake OHM for high yields. But the model faced a similar problem: Investors who only wanted to profit from the token left to find other opportunities, diminishing confidence in the sustainability of the protocol. Until the DeFi industry resolves the transactional nature of liquidity, there are no future changes to liquidity pools. *Translated by Daniela Pereira do Nascimento with permission from Decrypt.co.