An essential component of the DeFi ecosystem, a liquidity pool provides liquidity on a platform in order to facilitate the decentralized trading that takes place there. The liquidity pool itself comprises a collection of tokens or assets, supplied by liquidity providers. These tokens or assets are locked in a smart contract on the DeFi platform. The smart contract allows anyone to deposit their crypto assets into the liquidity pool and to receive a reward, usually in the form of trading fees, in return for the deposit, which helps to provide liquidity on the platform.
The DeFi platforms that utilize liquidity pools include lending platforms and decentralized exchanges (DEX). Lending platforms generally use a single asset liquidity pool to establish a decentralized lending and borrowing market. A DEX, however, requires a liquidity pool that consists of two or more tokens, as it facilitates the buying and selling of crypto tokens. Although the Ethereum-based Bancor is one of the first DEXs to utilize a liquidity pool, it was Uniswap that popularized the system.
What Goes On in a Liquidity Pool?
The collection of assets in the liquidity pool can be from a single cryptocurrency — or even up to eight different types of crypto assets, depending on the DeFi platform’s requirements. The originator of the liquidity pool gets to set the starting price of the asset, which should be in line with the global crypto marketplace to ensure that liquidity providers don’t suffer a loss in capital that they’ve deposited into the pool.
Generally, the liquidity pool facilitates token swaps between two tokens, also known as the trading pair. Pricing is automatically adjusted, based on the pool’s pricing algorithm. The pricing algorithm is also referred to as an automated market maker (AMM), which serves to ensure constant liquidity in the pool. This means that the token availability in the pool can affect its price. For example, when someone purchases Token A with Token B, the volume of Token B increases in the pool, while the number of Token A is reduced, hence resulting in the rise in price of Token A and a drop in Token B’s price. In a larger pool, such price fluctuations may be less pronounced, unless a large trade occurs that affects the overall quantity of the tokens.
Benefits of a Liquidity Pool
There are many benefits of a liquidity pool for different stakeholders of a DeFi platform. For traders, a pre-funded liquidity pool helps to ensure sufficient liquidity to facilitate their decentralized trade transactions at any time — without both buyer and seller needing to be in place for a direct exchange of assets. This helps to reduce the risk of slippage, especially in a large liquidity pool. While a smaller pool may be susceptible to price fluctuations, based on token availability, a large, established pool provides a more balanced and stable option when it comes to trading, buying and selling cryptocurrencies.
As for liquidity providers, they can earn transaction fees when they deposit their assets in the pool so that others can buy and sell. These fees can be added back to the pool to increase their percentage of contribution to the pool, and to increase the value of their deposited assets. A liquidity pool is open for anyone with assets to deposit, from which they can earn a passive income.
In addition, users are able to maintain control of their crypto assets, along with the possibility of earning governance tokens for a say in the decision-making process regarding the pool’s development and maintenance.