The easiest way to understand liquidity pools is to think of them like a pool you might have in your backyard. However, instead of being filled with water, these pools are filled with different cryptocurrencies.
Liquidity providers are traders who stake their crypto by adding their tokens to liquidity pools. These providers are rewarded with a share of the trading fees from transactions in the pool.
When a trader comes along to purchase a certain cryptocurrency, there doesn’t need to be a seller at that exact time, just a sufficient amount of liquidity in the pool. This is ultimately what makes liquidity pools so valuable.
What it means to be a liquidity provider
Liquidity providers provide liquidity to Decentralized Exchanges (DEXs) by locking (staking) their assets in a smart contract. You might ask, “why would anyone be willing to lock up their crypto assets for a certain amount of time?” This is where the rewards come in. Liquidity protocols such as UniSwap and Balancer incentivize liquidity providers by compensating them with trading fees, equivalent to their share of the total liquidity in the pool.
You can always dig deeper into what it means to be a liquidity provider, but for the purpose of this article that is all I will cover. What you really need to know is that nearly anyone can be a liquidity provider, and without providers a liquidity pool is nonexistent.
Why liquidity pools are important
The order book model is something that is seen commonly in traditional finance, such as stock exchanges. This method of trade brings buyers and sellers together; buyers state the price they are willing to pay for a certain asset, and sellers state the price they are willing to sell that asset for. If they agree on a price, the transaction goes through.
Because the order book model requires two people to come together at the same time and agree on a price, it doesn’t work well in the crypto space. When DeFi was still gaining exposure in its early years, traditional market makers didn’t supply the level of liquidity that the market needed. Liquidity pools solved this problem by incentivizing providers to bring liquidity to the market.
Another key reason that liquidity pools work so well in DeFi is that they are decentralized. There doesn’t need to be a centralized organization or person facilitating these trades, as liquidity is locked inside of a smart contract. DeFi allows anyone with an internet connection to conduct peer-to-peer transactions, cutting out unnecessary third parties.
Why liquidity matters
Many investors take liquidity into account when deciding which assets to purchase.
“Liquidity measures how quickly an asset can be sold without a drastic change in the asset’s price. You may have trouble selling your car within a day at market value, but if you offered to sell it for 90% off you could sell it within a couple of hours. For this reason, a car is considered to be an illiquid asset.” (How Liquid Is an NFT?)
Liquidity is important in crypto because higher levels of liquidity equate to lower slippage. Slippage is the difference in the expected price of the trade relative to the actual price when the transaction is carried out. This can result in the purchaser paying a higher price for that asset or receiving less of it.
The risks of liquidity pools
As unfortunate as it is, nothing is perfect. Liquidity pools are no exception. Impermanent loss is a term many come across but have trouble truly understanding. It is essentially a potential loss of value due to price volatility. This occurs because when liquidity providers lock up their crypto in smart contracts, they lose the ability to sell them. Pretty much every liquidity provider experiences impermanent loss, but the degree of significance can widely vary.
Another potential risk stemming from liquidity pools is smart contract risks. As mentioned above, smart contracts are what store the crypto provided by liquidity providers. The funds in a smart contract could be lost/stolen forever if someone finds an exploit or bug. While this isn’t something that often occurs, it is still important to be aware of the risk.
There are many other important terms and processes that I didn’t go into depth on or even cover, such as impermanent loss and automated market makers (AMMs). I plan to cover more “intermediate” terms in-depth in future articles. Here I simply aimed to cover the basics and provide a general understanding for those new to crypto/DeFi.
Liquidity pools are designed to increase liquidity for cryptocurrencies by rewarding liquidity providers with a portion of trading fees.