What is a Liquidity Pool in Decentralized Finance?

Liquidity refers to the possibility of an asset being quickly sold and exchanged for another asset without affecting its price. In short, it is an indication of how easily an asset can be converted into cash.

A liquidity pool is an accumulation of digital assets that allows assets to be traded on a decentralized exchange (DEX). A DEX is a type of exchange that functions without an intermediary, allowing assets to be traded with each other directly.

With the DeFi platforms, users can borrow, lend crypto assets, and earn other crypto assets in return. Smart contracts are used to automatically facilitate yield farming, requiring minimum human intervention while conducting transactions efficiently. Yield farming maximizes the user’s returns by depositing crypto assets into a pool with other users.

In this blog we will cover the following:

1. Purpose & Importance of Liquidity Pools in DeFi
2. How Liquidity Pools in DeFi work?
3. Advantages of Liquidity Pools
4. Disadvantages of Liquidity Pools
5. How to create a Liquidity Pool in DeFi
6. Frequently Asked Questions

• Why are liquidity pools needed?
• What is a good liquidity pool?

Purpose & Importance of Liquidity Pools in DeFi

The main purpose of liquidity pools is to allow peer-to-peer trading to function smoothly on DEXs. By fuelling liquidity constantly through a steady supply of buyers and sellers, liquidity pools ensure trading is executed quickly and efficiently.

Liquidity pools are an integral part of DeFi as peer-to-peer trading cannot function without them. There are several use cases of liquidity pools in DeFi:

• With liquidity pools, users can trade on DEXs
• Liquidity pools create the liquidity that is crucial for the DEXs to function. Without the required liquidity, it would be difficult to trade on DEXs
• Liquidity pools do not require intermediaries to function and allow users to deposit their assets using smart contracts and then trade the tokens on DEXs
• By utilising Automated Market Makers (AMMs), liquidity pools automatically match buyers and sellers and set prices, increasing the overall market efficiency.
• Through liquidity pools, users can make additional income on their digital assets by locking their assets in a smart contract and earning a portion of the fees generated via trading activities.

How Liquidity Pools in DeFi work?

When users, also called Liquidity providers (LPs) deposit their digital assets into a smart contract, liquidity pools are created. LPs can then trade these assets with each other on a DEX. Users are issued liquidity pool tokens (LPTs) which represent the LP’s share of assets in the pool.

Yield farming involves a liquidity provider (LP) and a liquidity pool in Decentralized Finance. Think of a liquidity provider as an investor who deposits tokens into a smart contract to fuel liquidity. Yield farming works on the automated market maker (AMM) model which eliminates the need for the conventional order book and instead creates liquidity pools using smart contracts.

AMM deploys a mathematical formula for calculating the need for swapping each asset and the trading fee to be paid out to the LPs is then determined.

Liquidity pools are a part of the Yield Farming process. Yield farming in DeFi begins with the process of creating a pool of crypto assets. The following steps are undertaken to facilitate yield farming:

• Liquidity pool: Creating a liquidity pool is the first step within yield farming. Investing and borrowing within specific yield farms are facilitated by the use of smart contacts.
  
• Depositing assets: Users can connect their digital asset wallet for depositing assets within the liquidity pool. Also called staking, this process is similar to users depositing in their bank accounts or investing in a mutual fund.
  
• Smart Contracts: Smart contracts, which are self-executed computer codes, allow several processes such as providing liquidity to a crypto exchange, lending, borrowing, etc.
  
• Rewards: Once you have entered the liquidity pool, you start earning rewards in the form of interests that vary by yield farm. The rewards could be paid at regular intervals or a later date in the future, depending on the terms agreed upon.

Read more: Lending & Borrowing in DeFi

Advantages of Liquidity Pools

• The liquidity pool injects liquidity into the DEXs and lending platforms for smooth functioning.
• LPs can earn passive income through multiple revenue streams by supplying their tokens on different DeFi protocols.
• Through decentralisation anyone can take part in the liquidity pools, empowering users to be a part of the financial system.

Read more: Yield Farming vs Staking in DeFi

Disadvantages of Liquidity Pools

Just like any other investment, there are risks with liquidity pools too.

• Smart Contracts Risk: This type of risk is a major one as hackers can potentially find a bug in the smart contract and could steal assets from the liquidity pool. One such instance happened in 2020 with the Balancer protocol where a hacker borrowed a large number of tokens from the protocol in the form of flash loans and drained all the funds, leading to a smart contract exploit. Hence, it is advisable to invest in pools that have been verified and audited by specialised firms, minimising your chances of being attached.
  
• Impermanent Loss: This is a type of risk that arises from the price of an asset fluctuating. If the price of the underlying asset increases, the value of the tokens within the pool will increase and vice versa, having a major effect on the value of the pool overall. It is considered to be a risk because there could be a chance that the price of the asset may never recover at all.

How to Create a Liquidity Pool in DeFi?

For creating a liquidity pool in decentralized finance, users need to deposit two equal amounts of assets within a pool. This is referred to as the “trading pairs”

For example, if you wish to invest in a pool with the token pair BTC/USDT, you are required to deposit an equal amount of both ETH and USDT into the pool to begin trading.

Generally, one would need equal amounts of assets and manually enter them into the pool to trade. However, Okto, a DeFi wallet app such as Okto makes it easier for users to explore vetted investment opportunities and explore liquidity pools with higher APYs. One of the major hindrances within yield farming is the complexities involved with using various platforms to farm and make additional income on your crypto. However, Okto’s user interface is designed in a way that makes it easy for a novice user to explore varied opportunities across pools on a single app and invest securely.

Read more: What are Meme Coins

Frequently Asked Questions

Why are liquidity pools needed?

Liquidity Pools are needed to facilitate the functioning of the DeFi world by providing liquidity in the market. In exchange, they reward the users through trading fees. Moreover, they provide financial independence as there are no intermediaries involved and are governed by smart contracts that facilitate buying and selling automatically. Eliminating middlemen also increases market efficiency and ensures the smooth functioning of the protocols.

What is a good liquidity pool?

A good liquidity pool in DeFi is one that is less prone to smart contract bugs and has been audited by a reputable company for the same. The protocol should have some form of on-chain insurance mechanism in place to protect its LPs and provide protection for impermanent loss.

Ideally, a good liquidity pool would have a higher trading volume and a large amount of liquidity. One must also consider the fees associated with the pool.

Read more: Indicators every DeFi Investor should know!