What Are Liquidity Pools? Beginner’s Guide

The traditional finance world runs on liquidity. So unavailability of funds would cause the financial systems to crash. The same is true for Decentralized Finance (DeFi), a term used to describe financial services on blockchain.

DeFi activities like borrowing, lending, or token-swapping usually rely on smart contracts, which enable users to lock up their crypto into liquidity pools for others to use. These liquidity pools are attractive to investors that are willing to risk big to get high rewards.

How do Liquidity Pools Work?

Every economic activity in the DeFi requires crypto. Therefore, DeFi protocols create liquidity pools to allow users to deposit crypto assets to ensure an adequate supply of crypto. These liquidity pools are self-executing, meaning they do not require any broker to make them work. In addition, they’re supported by automated market makers, which help maintain the balance in the pools using mathematical formulas.

Why is Low Liquidity a Problem?

Low liquidity causes high slippage (a big difference between the expected token price and the price it actually trades for). So if a liquidity pool has few tokens, and a user wishes to swap their crypto, they should brace themselves for inflated prices.

However, high slippage is not the only problem stemming from low liquidity. Here is another one. Let’s say there is inadequate liquidity for a certain trading pair like ETH to TUSD on all protocols; this would mean that users won’t be able to sell and will be stuck with worthless tokens. That’s exactly what happens with many rug pulls.

How Much Liquidity is There in DeFi?

Liquidity in DeFi is expressed in terms of TVL (Total Locked Value), which measures the amount of crypto that has been entrusted into various protocols. According to data from metrics site DeFi Llama, the TVL in the entire DeFi space sits at $50 billion as of March 2023.

Why Provide Liquidity to a Pool?

For crypto investors, providing liquidity can be a lucrative venture. Most DeFi protocols reward liquidity providers with LP tokens. In addition, these tokens can be staked on other protocols to generate more passive income.

However, beware of risks. All liquidity pools are subject to impermanent loss, a term used in DeFi when the ratio of tokens in a pool becomes uneven as a result of massive price changes. This could lead to losing your investment.

Which DeFi Projects are Using Liquidity pools?

Most of the projects in the DeFi space that have created liquidity pools are exchanges and lending protocols. Some of them include 1inch, a decentralized exchange aggregator that is supported by multiple chains; Aave, a decentralized borrowing and lending platform; and Uniswap, a decentralized exchange for swapping tokens built on Ethereum.

How Can You Add Liquidity?

If you wish to add funds to a certain liquidity pool, like, for example, ETH/USDC liquidity pool, you are required to have even amounts of USDC and ETH, which you can swap using a decentralized exchange. But if you find swapping to be tiresome, you can ‘zap’ your crypto into any liquidity pool. Zapping means adding liquidity in only one transaction using a platform like Zapper. This platform will swap your crypto into equal amounts of the relevant pair.

The Future of Liquidity Pools

Blockchain analytics firm Nansen recently reported that about 40% of liquidity providers exit pools within 24 hours of joining. To handle this problem, the DeFi project OlympusDAO has moved away from creating liquidity pools to letting users sell their crypto assets into the protocol’s treasury in exchange for OlympusDAO’s native token OHM, which users can stake for high yields.