Liquidity Pool in DeFi Simply Explained

A Liquidity Pool is a smart contract that collects large amounts of assets. The goal is to ensure the liquidity of a decentralized exchange or protocol. Liquidity Providers are DeFi users who deposit assets to a liquidity pool.

Liquidity Pool Explained

At first, the concept of a Liquidity Pool came with the advent of Automated Market Makers (AMMs). AMMs leverage liquidity pools to ensure liquidity for trading. In stark contrast to order book exchanges, AMMs rely on large funds to provide liquidity. While order book exchanges bring together buyers and sellers, AMMs depend on so-called “token pairs” to find the market price.

Liquidity pools have turned out to be an effective way to find prices on the blockchain. While order books require complex smart contracts, AMMs are way more gas efficient.

However, AMMs are only one implementation of liquidity pools. We call any kind of smart contract collecting user’s funds a liquidity pool.

On the other hand, liquidity providers are DeFi participants who deposit assets into liquidity pools. Therefore, liquidity providers are the ones responsible for keeping the protocol liquid.

Liquidity Pool in AMMs

A straightforward form of a liquidity pool is a token pair, typically inside an AMM like Uniswap. For example, let’s take a look at the DAI/USDC token pair.

Liquidity providers provide the same amount of DAI and USDC to the liquidity pool. In our example, the liquidity provider deposits $1,000 in DAI and USDC into the pool. The liquidity pool would look like this:

  • $1,000 DAI
  • $1,000 USDC

When they deposit funds, liquidity providers receive liquidity provider tokens (LP tokens). These tokens represent the right to withdraw their funds from the pool at any time. To withdraw their assets from the liquidity pool, they simply burn their LP tokens.

When someone wants to trade USDC for DAI, they put in USDC and take the equivalent amount of DAI out of the pool. That’s how liquidity pools can avoid the traditional order book model. Only a liquidity pool is needed to find the market price.

For every trade, traders have to pay transaction fees. The fees are the liquidity provider’s rewards for putting their money at smart contract risk. Usually, the trading fees range from 0.05% to 1% of the volume, which is more than enough to compensate for the risks liquidity providers take.

Liquidity Pool in Money Markets

Money Markets are another great example: these markets serve the purpose of lending and borrowing money.

Liquidity Providers deposit money into the liquidity pool to lend money to other DeFi users. These pools are large funds of assets that offer lending services for various DeFi tokens. 

Furthermore, interest rates are determined by supply and demand. In traditional finance, interest rates only reflect the decisions made by central banks. In DeFi, the interest rate will rise when the number of borrowers increases. On the flip side, interest rates will decrease when the number of lenders increases.

In addition, Money Market liquidity pools offer the ability to take so-called “flash loans.” These are loans without collateral. Anyone could take any amount of credit with the promise to pay back the loan in the same transaction. AAVE introduced flash loans to increase the efficiency of the DeFi ecosystem. Flash loans allow anyone to borrow money in real-time without having to provide collateral. When you see an arbitrage opportunity in DeFi, you can easily exploit it within seconds.

Liquidity Provider Tokens

LP tokens represent a LP’s share of a pool. The liquidity provider holds these tokens in his wallet and can transfer them freely.

For example, if you deposited $100 worth of assets to a Uniswap pool with a total value of $1,000, the liquidity provider would receive 10% of that pool’s liquidity provider tokens. Also, the liquidity provider receives 10% of the LP tokens because he owns 10% of the crypto liquidity pool.

The LP tokens represent a claim to the share of the pool’s assets. If you hold LP tokens in your wallet, you can withdraw your share at any given time. Most LP tokens are ERC-20 tokens. That means you can transfer, exchange, and even stake them.

If you want to withdraw your tokens from the pool, you burn the LP tokens and receive back your share of the pool.

Popular DeFi Liquidity Pools

Almost all DeFi protocols have some liquidity pools. Here is a list of the most common ones:

  • Uniswap
  • Aave
  • Compound
  • MakerDAO
  • SushiSwap
  • Balancer
  • Curve
  • YFI
  • InstaDapp
  • Bancor
  • Synthetix
  • Nexus Mutual

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