Blockchain

Here are how liquidity pools work and the keys to DeFi's success

The world of finance revolves around liquidity. Financial systems come to a standstill when money is not accessible. DeFi, or decentralized finance, is a catch-all name for financial services and blockchain-based businesses.

Smart contracts are self-executing codes used in DeFi activities like lending, borrowing, and token exchanging. Users of the DeFi protocol "lock" cryptocurrency assets into these liquidity pools so that others can utilize them.

Liquidity pools are a crypto industry invention with no direct counterpart in traditional finance. Liquidity pools, in addition to giving a lifeline to a DeFi protocol's basic operations, also function as hotbeds for investors with a penchant for high risk and big profit.

How Do Liquidity Pools Work?

If you look past the technical jargon, the underlying logic of liquidity pools is self-evident. Any economic activity in DeFi requires crypto. And that crypto needs to be supplied somehow, which is exactly what liquidity pools are designed to achieve.

When a user sells token A to purchase token B on a decentralized exchange, they rely on tokens from the A/B liquidity pool other users give. When they buy B tokens, the pool will have fewer B tokens, causing the price of B to climb. That is fundamental supply and demand economics.

Liquidity pools are smart contracts that include locked crypto tokens donated by platform users. They are self-executing and do not require intermediaries to function. They are assisted by other pieces of code, such as automated market makers (AMMs), which use mathematical algorithms to keep liquidity pools balanced.

Why is Low Liquidity a Problem?

Due to a lack of liquidity, there is a substantial discrepancy between the predicted price of a token trade and the price at which it is performed. Token changes in a pool, whether as a result of a swap or any other activity, induce bigger imbalances since there are so few tokens locked up in pools. The pool will not experience much slippage if it is very liquid.

However, substantial slippage is hardly the worst-case situation. If there is insufficient liquidity for a certain trading pair (say, ETH to COMP) across all protocols, consumers will be trapped with tokens they cannot sell. This is similar to rug pulls but can also happen organically if the market does not supply adequate liquidity.

How Much Liquidity is There in DeFi?

Liquidity in DeFi is often represented in terms of "total value locked," which measures how much crypto is entrusted into protocols. According to monitoring site DeFi Llama, the TVL in DeFi as of March 2023 was US$50 billion.

TVL also helps to reflect the rapid expansion of DeFi: In early 2020, Ethereum-based protocols had a TVL of only US$1 billion.

Why Provide Liquidity to a Pool?

Liquidity in DeFi is often represented in terms of "total value locked," which measures how much crypto is entrusted into protocols. According to monitoring site DeFi Llama, the TVL in DeFi as of March 2023 was US$50 billion.

TVL also helps to reflect the rapid expansion of DeFi: In early 2020, Ethereum-based protocols had a TVL of only US$1 billion.

Most liquidity pools also give LP tokens, which act as a form of receipt and may subsequently be traded for pool benefits equal to the liquidity provided. LP tokens can occasionally be staked on other protocols to create even higher payouts.

However, be wary of hazards. Impermanent loss occurs when the token ratio in a liquidity pool (for example, a 50:50 split of ETH/USDT) becomes unequal owing to severe price movements. This may result in the loss of your invested cash.

The Future of Liquidity Pools

Liquidity pools exist in a competitive market, and recruiting liquidity is difficult when investors continuously seek high yields elsewhere and take the liquidity.

According to Nansen, a blockchain analytics firm, 42% of yield farmers that offer liquidity to a pool on opening day leave the pool within 24 hours. 70% will have vanished by the third day.

However, the model has encountered a similar issue: investors who want to cash out the token and move on to other options, reducing trust in the protocol's long-term viability.

There won't be much change for liquidity pools until DeFi fixes the transactional nature of liquidity.