TL;DR - SUMMARY

Liquidity pools are one of the founding technologies of the current DeFi ecosystem. They constitute an essential part of automated market makers (AMM), lending protocols (borrow/lend), yield farming, synthetic assets, on-chain insurance coverage, blockchain-based gaming – the list is endless.

In itself, the idea is profoundly simple. Liquidity pools are basically funds piled up together in a large digital pile. But what can you do with this stack in a non-permissioned environment, where anyone can add liquidity? Let's see how DeFi has iterated the idea of ​​"liquidity pools" or liquidity reserves.


Introduction

Decentralized Finance (DeFi) has generated an explosion of “on-chain” activity. DEX volumes can significantly compete with those of centralized exchanges. As of December 2020, the value locked in escrow in DeFi protocols is almost $15 billion. The ecosystem is rapidly expanding with new types of products.

But what makes all this expansion possible? One of the fundamental technologies behind these products is the "liquidity pool" or liquidity reserve.


What is a liquidity pool?

A "liquidity pool" or liquidity reserve is a set of funds blocked on deposit in a "smart contract". Liquidity reserves are used to facilitate decentralized trading and lending, as well as many other functionalities that we will explore later.

Liquidity pools are the backbone of many decentralized exchanges (DEX), such as Uniswap. A type of users called liquidity providers (LPs) provide an equivalent value of two tokens in a reserve (pool) to create a market. In exchange for contributing their funds, they will earn trading commissions from the trades that take place in their "pool" or reserve, proportional to their participation in the total liquidity.

Since anyone can be a liquidity provider, AMMs have made market making more accessible.

One of the first protocols to use “liquidity pools” would be Bancor, although the concept would attract more attention with the popularization of Uniswap. Other popular exchanges on Ethereum that use liquidity pools are SushiSwap, Curve, and Balancer. The liquidity reserves of these platforms contain ERC-20 tokens. Other similar equivalents on Binance Smart Chain (BSC) are PancakeSwap, BakerySwap and BurgerSwap - whose "pools" contain BEP-20 tokens.


Liquidity pools vs. order books

To understand how "liquidity pools" or liquidity reserves are different, we are going to analyze the fundamental pillar of electronic trading – the order book. Simply put, the order book is a collection of the currently open orders for a particular market.

The system that matches orders with each other is called matching engine. Along with the matching engine, the order book is the core of every centralized exchange (CEX). This model is great for facilitating efficient exchanges, and allowed for the creation of complex financial markets.

Trading in DeFi, however, involves executing trades on-chain, without a centralized third party in possession of the funds. This is a problem when it comes to order books. Every interaction with the order book requires gas fees, making it much more expensive to execute trades.

It also makes the work of market makers - traders who provide liquidity to tradable pairs - very expensive. But above all, most blockchains cannot offer the performance necessary to trade trillions of dollars every day.

This means that on a blockchain like Ethereum, an exchange with an on-chain order book is practically impossible. You could use sidechains or layer 2 type solutions, which are already on the way. However, in its current form, the network is not capable of delivering the necessary performance.

Before continuing, it is worth noting that there are DEXes that seem to work well with on-chain order books. Binance DEX has been built on Binance Chain, and is specifically designed for fast and low-cost trading. Another example is Project Serum, under construction on the Solana blockchain.

Despite this, since many of the assets in the crypto sector are located on Ethereum, it will not be possible to trade them on other networks, unless you use some type of cross-chain bridge.


How do liquidity pools work?

Automated market makers (AMM) have changed the rules of the game. They are a significant innovation that enables on-chain trading without the need for an order book. Since no direct counterparty is needed to execute trades, traders can enter and exit positions in token pairs that would likely be very illiquid on order book-based exchanges.

You can imagine an order book exchange as a peer-to-peer platform, where buyers and sellers are connected by the order book. For example, trading on Binance DEX is peer-to-peer since trades are carried out directly between users' wallets.

Trading using an AMM is different. You can imagine trading on an AMM as peer-to-contract.

As we have mentioned, a liquidity reserve (liquidity pool) is a set of funds deposited in a "smart contract" by liquidity providers. When you execute a trade on an AMM, you will not have a counterparty in the traditional sense. Instead, you will execute the trade against the liquidity in the liquidity pool. For the buyer to buy, it is not necessary that there be a seller at the moment, but only sufficient liquidity in the reserve.

When you buy the last food coin on Uniswap, there is no seller on the other side in the traditional sense. Instead, your activity is managed by the algorithm that governs what happens on the reservation. Furthermore, the price is also determined by this algorithm based on the operations that occur in the reserve. If you want to dive deeper into how this works, read our article on AMM.

Of course, liquidity has to go somewhere, and anyone can be a liquidity provider, so they could be seen as your counterparty in some sense. But, it is not the same as in the case of the order book model, since you are interacting with the contract that governs the reservation.


What are liquidity reserves used for?

So far, we have mainly talked about AMMs, which have been the most popular use of liquidity reserves. However, as we have said, liquidity pooling is a profoundly simple concept, so it can be used in a number of different ways.

One of them is yield farming or liquidity mining. Liquidity reserves are the basis of automated yield generation platforms like yearn, where users add their funds to reserves which are then used to generate yield.

Getting new tokens into the hands of the right people is a very difficult problem for crypto projects. Liquidity mining has been one of the most successful approaches. Basically, tokens are distributed algorithmically to users who put their tokens into a liquidity pool. The newly minted tokens are then distributed proportionally to each user's stake in the pool.

Consider; These may even be tokens from other liquidity pools called pool tokens. For example, if you are providing liquidity to Uniswap or lending funds to Compound, you will earn tokens that represent your stake in the reserve. You may be able to deposit those tokens into another pool and get a refund. These chains can get quite complicated, as protocols integrate reserve tokens from other protocols into their products, and so on.

We could also think of governance as a use case. In some cases, a very high threshold of symbolic votes is needed to be able to present a formal governance proposal. If, instead, the funds are pooled, participants can join a common cause that they consider important to the protocol.

Another emerging DeFi sector is smart contract risk insurance. Many of their implementations also work with liquidity reserves.

Another even more innovative use of common liquidity reserves is tranching. It is a concept taken from traditional finance that involves dividing financial products based on their risks and benefits. As expected, these products allow LPs to select customized risk and return profiles.

The minting of synthetic assets on the blockchain also depends on liquidity reserves. Add some collateral to a liquidity pool, connect it to a trusted oracle, and you've got a synthetic token that's pegged to any asset you want. Okay, actually, it's a more complicated problem than that, but the basic idea is that simple.

What else can we think of? There are probably many more uses for liquidity pools that have yet to be discovered, and it all depends on the ingenuity of DeFi developers.


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The risks of liquidity reserves

If you provide liquidity to an AMM, you should be aware of a concept called impermanent loss. In short, it is a loss of dollar value compared to HODLing when you provide liquidity to an AMM.

If you are providing liquidity to an AMM, you are probably exposed to an impermanent loss. Sometimes it can be tiny; sometimes it can be huge. Be sure to read our article on this if you are considering placing funds in a two-sided liquidity pool.

Another thing to keep in mind is the risks of smart contracts. When you deposit funds into a liquidity reserve, they are in the reserve. So while there are technically no intermediaries holding your funds, the contract itself can be considered the custodian of those funds. If there is a mistake or some type of exploit through a flash loan, for example, your funds could be lost forever.

Also, be wary of projects where developers have permission to change the rules governing the reservation. Sometimes developers may have an administrator key or some other privileged access within the smart contract code. This can allow them to do something potentially malicious, such as taking control of the reserve funds. Read our article on DeFi scams to try to avoid rug pulls and exit scams as best you can.


In conclusion

Liquidity reserves are one of the core technologies behind the current DeFi technology stack. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power almost every part of DeFi, and will most likely continue to do so.