What Are DeFi Liquidity Pools & What Do They Do?

Anyone who’s spent any time considering whether or not to invest in DeFi has probably heard of liquidity pools. They’re a key element of automated market makers, borrowing and lending protocols, synthetic assets, yield framing, on-chain insurance and other aspects of DeFi. 

But what is a liquidity pool exactly? 

It’s actually fairly simple – they serve as a big pool of funds that comes from multiple users. However, they serve many different purposes, as we shall learn below.

Liquidity Pools Explained

As we’ve established, liquidity pools are a large collection of funds that are locked into smart contracts, used to facilitate multiple DeFi services, including decentralized trading, borrowing and lending. 

It’s not an exaggeration to say that liquidity pools are absolutely key to DeFi. They’re what enable decentralized exchanges, or DEXs, such as Uniswap to operate. The way it works is that users add an equal amount of two different types of cryptocurrency token into a pool – for instance BTC and USDC. This creates liquidity for other users to be able to trade those two cryptocurrencies, and in return, the liquidity providers will earn fees from those trades, in proportion to their share of the total amount of funds within the pool. 

One of the great things about DeFi is that anyone can participate as a liquidity provider and earn rewards for doing so. Bancor was one of the first DEXs to establish the concept, however it was at Uniswap that the idea really took off. Nowadays, of course, there are multiple DEXs around that use liquidity pools, including Curve, Balancer and SushiSwap. These Ethereum-based services provide dozens of liquidity pools for all manner of ERC-20 tokens. Other blockchains, such as BNB Smart Chain, have their own protocols like PancakeSwap and BurgerSwap, which provide liquidity pools for BEP-20 tokens. 

Automated Market Makers vs Order Books

DEXs work differently from centralized exchange platforms such as Binance. Instead of using AMMs and liquidity pools, CEXs use the order book, which collects open orders from the exchange users. 

CEXs employ a system called a “matching engine” that matches buy and sell orders within the order book. These two elements therefore serve as the core of any CEX, facilitating efficient exchanges between users and enabling the creation of extremely complex financial markets. 

In DeFi, because there’s no centralized entity running the show, there can be no order books. DeFi transactions must be executed on-chain because there’s no one to hold the funds in a central wallet and match the orders.

The AMM is a significant innovation that enables on-chain trading without the use of an order book. With no centralized entity to facilitate trading, it’s possible for users to enter and exit their positions on token pairs that would likely be extremely illiquid on order book-based exchanges. 

An order book exchange can be thought of as “peer-to-peer”, with the order book connecting the buyers with the sellers. This is how Binance works, with trades taking place directly between user’s wallets. 

The AMM works differently, and might be thought of as “peer-to-contract”. By this, we mean when someone executes a trade on an AMM-based DEX, they’re not interacting with any counterparty. Instead, they trade against the liquidity that’s held within the liquidity pool. So the buyer doesn’t need a seller to match their order, so long as there is sufficient liquidity in the pool to fulfill their order. 

So if someone decides to buy the latest memecoin on Curve, they don’t need to find a seller. Rather, their activity is managed by the automated algorithm that controls the liquidity pool. The price at which they can trade is determined by this algorithm, based on the current supply and demand for each specific asset. 

Liquidity Pools For Yield Farming 

While AMMs were the first services to pioneer the use of liquidity pools, they’re not the only one that can make use of them. 

For instance, liquidity pools also play a key role in what’s known as yield farming or liquidity mining. They serve as the foundation of yield-generating protocols like Yearn Finance, where users add funds to specific pools that will be used by algorithms to generate yield. 

Liquidity pools also facilitate the distribution of new cryptocurrency tokens. When a new project first launches its token, it can be tricky to get them in the hands of the right people. Liquidity mining can help with this. What happens is that the newly-minted tokens are distributed algorithmically among users who deposit other tokens into a liquidity pool. The algorithm ensures that each liquidity provider receives a proportional amount of tokens compared to what they donated to the pool. 

Some liquidity pools even distribute their own native tokens to users, as an additional reward to the fees they earn from trades against the pool. For instance, if users deposit BAL into a lending pool on Balancer, they’ll receive veBAL tokens in return. veBAL tokens are governance tokens that provide voting rights to users. This requirement that users deposit BAL tokens to be able to vote ensures that Balancer will always have sufficient liquidity. 

Liquidity pool tokens such as veBAL can then be deposited into other liquidity pools to earn even greater returns. This is where DeFi can get complicated, resulting in multiple protocols that integrate with the tokens of other pool protocols. 

Maximizing Liquidity Pool Rewards

This complexity is best evidenced by the rise of so-called meta-protocols, which rely on another protocol. Within the Balancer DeFi ecosystem, a popular meta-protocol called Aura Finance has emerged, giving veBAL holders the opportunity to pool their voting rights and earn additional rewards for doing so. 

What Aura does is it asks users to lock veBAL into its protocol, making a commitment not to withdraw for a certain period of time. By locking up veBAL within Aura, the protocol is able to collectivize its governance voting power. One thing to remember is that veBAL’s voting power is time-weighted, meaning that each token gains more weight in governance votes the longer it is locked up for. Aura ensures its veBAL tokens are locked up for the longest time possible. It can then use its voting power to influence which liquidity pools earn the most rewards, serving as a powerful tool for new crypto projects that need to increase the liquidity of their own tokens. 

Aura incentivizes users to supply liquidity to its pool by issuing yet another token, called auraBAL, for each veBAL token they provide. These auraBAL tokens can then be staked on Balancer to earn yet more rewards. 

Additional Uses Of Liquidity Pools

Besides yield farming, there are other uses of liquidity pools in DeFi. One of the most popular is insurance against smart contract vulnerabilities. This is an emerging area that makes it possible for DeFi users to take out an insurance policy against a protocol being hacked, with compensation for users paid out from liquidity pools in the event that the user’s funds are stolen. 

A more cutting-edge use case is something known as “tranching“, which is an idea borrowed from the world of traditional finance. Tranching involves splitting up multiple financial products based on their level of risk and potential returns. With these products, users can customize their risk versus return profile to suit their needs. 

The minting of synthetic assets, such as wrapped BTC (wBTC) also relies on liquidity pools. By adding BTC collateral to a liquidity pool and connecting it to a trusted oracle, it becomes possible to create a wBTC token that’s pegged to the original asset. Of course, there is a lot of complexity involved but the basic idea is simple enough. 

What Are The Risks Of Liquidity Pools?

The exact risks depend on what the purpose of the liquidity pool is. One of the biggest risks for those depositing assets in liquidity pools that enable trading is something known as “impermanent loss“. This is where the liquidity pool providers suffer a dollar value loss, usually resulting from a sharp drop in the price of an asset, compared to if they were simply holding that token in a crypto wallet. Impermanent loss is a common risk, and although the amount lost is usually negligible, it can sometimes be enormous during periods of crypto market volatility. 

A second major risk for liquidity providers is smart contract vulnerabilities. When someone deposits their assets into a liquidity pool, what they’re really doing is locking them up within a smart contract. The contract effectively becomes the custodian of those funds, and that in itself is risky. If a malicious actor discovers an exploit in the smart contract’s code, they might be able to steal all of the funds within it, leaving the liquidity providers with nothing. 

DeFi users should also be wary of depositing funds into liquidity pools where developers retain the rights to change the smart contract that controls them. The developers might create an admin key or some other mechanism for privileged access within the smart contract. Through this, they could potentially steal the funds locked within it. This is how scammers in the crypto industry commonly operate, creating what looks to be a legitimate protocol and attracting liquidity before suddenly making off with all the funds – what’s known as a “rug pull”.

Final Thoughts

The importance of liquidity pools to DeFi is essentially unmatched. They are what makes the wheels go round in almost every aspect of DeFi, powering decentralized trading of tokens, yield farming, governance voting and many other use cases. For DeFi users, it’s important to understand what liquidity pools are and how they work, because they can become a key source of revenue to smart investors.