Liquidity Pools: The Core Mechanism Driving DeFi

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In the financial market, liquidity is a crucial factor as it reflects the flexibility and security of investment assets as well as their prices.

In this article, Tonraffles aims to introduce you to Liquidity Pools, a solution to liquidity issues in decentralized finance that is considered the backbone of DeFi.

What is a Liquidity Pool ?

Liquidity Pools, simply put, are groups of tokens locked in a DeFi smart contract. They are designed to enhance liquidity and address the issue of low liquidity, ensuring that the price of tokens does not fluctuate significantly after executing a large transaction.

Liquidity Providers (LPs) add equal value of two tokens into the liquidity pool to create a market. For each trading pair, LPs can earn transaction fees from providing liquidity.

• What Are Smart Contracts and How Do They Work ?
• Quick Guide: Learn How Blockchain Technology Works in 5 Minutes

How Does a Liquidity Pool Work?

In its simplest form, a liquidity pool contains 2 tokens, and each pool establishes a new market for the same token pair.

The first liquidity provider to a pool determines the initial price of the assets in the pool.

Based on the liquidity provided to a pool, liquidity providers (LPs) receive special tokens called LP tokens, which correspond to the amount of liquidity they provide to the pool. A 0.3% transaction fee is proportionally distributed to all LP token holders whenever the liquidity pool is utilized.

To reclaim their underlying liquidity plus any unpaid fees, LPs must burn their LP tokens. Each token swap transaction is incentivized by the liquidity pool, leading to a price change based on a deterministic pricing algorithm. This process is also known as an automated market maker (AMM).

How to Participate in a Liquidity Pool?

For example, if you want to provide $50 in liquidity to the CELO/USDC pool, you need to deposit $50 worth of CELO and $50 worth of USDC, totaling a $100 deposit. After providing liquidity to the pool, you will receive LP tokens corresponding to your deposited amount.

Whenever a transaction is executed, a transaction fee is deducted and sent to the smart contract containing the liquidity pool. The transaction fee is typically 0.3% for most decentralized exchanges.

The calculation is simple: with a $50 liquidity provision to the CELO/USDC pool, assuming you contribute 1% of the total liquidity, you will receive 1% of the 0.3% fee for every transaction.

Benefits and Risks of Liquidity Pools

Benefits

• Ensures liquidity at all price levels
• Creates passive markets through automated pricing algorithms
• Anyone can participate in providing liquidity and earn profits
• Reduces gas costs

Liquidity Pool profits depend on three factors:

1. The value of assets when deposited and withdrawn
2. The size of the liquidity pool
3. The trading volume

Risks

• Impermanent Loss: Losses due to the decline in the value of initially deposited tokens. This occurs when the ratio between the token pair changes due to significant market volatility.
• Smart Contract Bugs: Errors in the smart contract
• Hacker Attacks
• System Failures

Explanation of Impermanent Loss

Let’s assume you provide $50 in liquidity to the CELO/USDC pool, requiring you to deposit 50 CELO and 50 USDC (at $1 CELO = $1 USDC), totaling $100, with you owning 1% of the pool, which currently has 5000 CELO and 5000 USDC. After some time, the price of CELO rises to 5 USDC, changing the pool ratio to 2000 CELO and 10000 USDC to balance the CELO price.

If you withdraw your liquidity at this point by burning your LP tokens, you will receive 20 CELO and 100 USDC, totaling $200, giving you a $100 profit compared to your initial deposit. However, if you had held onto your 50 CELO and 50 USDC, their total value would now be $300.

“In reality, you would likely have much more profit if you simply held onto this amount instead of adding it to the LP. In this scenario, your loss wouldn’t be significant because the initial deposit is relatively small. However, remember that temporary losses can potentially lead to substantial impairments (constituting a significant portion of the initial deposit).

In many cases, the earned fees will offset the losses and generate profits for the liquidity provider. However, it’s crucial to understand impairment loss before providing liquidity to a DeFi protocol.”

How to effectively participate in providing liquidity?

In DeFi, there are always inherent risks beyond finding a reputable and secure protocol to avoid security risks and system failures. When you participate in providing liquidity, you also need to understand impairment loss clearly. Here are some tips to help you maximize your profit when participating in liquidity provision:

1. Stop providing liquidity when the market is highly volatile.
2. Choose liquidity pools with greater profit potential than impermanent loss.
3. Wait for the ratio between the two cryptocurrencies to return to the initial state before withdrawing liquidity.
4. Choose liquidity pools with low volatility, such as stablecoins.

Famous DeFi Liquidity Pools:

• Uniswap
• Balancer
• Bancor
• Convexity
• OIN Finance
• KeeperDAO
• ICTE
• DeversiFi
• Kyber Network
• Unipig and StarkDEX

Summary:

Through this article, you can see how important Liquidity Pools are in decentralized finance, right? I hope this article helps you understand liquidity pools, their risks, and benefits, so that you can participate in liquidity provision safely and effectively.

FAQ DeFi Liquidity Pools