Liquidity pool meaning

What are liquidity pools?

Liquidity pools are pools of staked cryptocurrency tokens that provide decentralised finance (DeFi) protocols with liquidity to facilitate trading and borrowing of cryptocurrencies.

Decentralised exchanges (DEXs) like Ethereum-based Uniswap allow cryptocurrency holders to provide liquidity by depositing pairs of tokens in exchange for a fee. As of 23 February, the DAI-USDC was the most popular pair on Uniswap, in terms of total value locked (TLV). So a user can deposit DAI and USDC at any preferred ratio to earn interest on their deposits.

DEXs are powered by Automated Market Maker (AMM) systems that leverage liquidity pools to autonomously match and execute market orders. AMMs eliminate the need for centralised exchanges.

“AMM-based DEXs replace order books with a ‘liquidity pool’. The liquidity pool is funded by ‘liquidity providers’, which are typically incentivised by shares of trading fees and issuance of tokens by the DEX. AMMs provide pricing based on an algorithm, allowing instant quotes regardless of the depth of the liquidity pool,” said audit and advisory firm KPMG in its Crypto Insights report.

“Liquidity on traditional asset exchanges has historically been provided by a small handful of professional trading firms with permissioned access and specialised tools,” added crypto trading platform Bancor.

How does a liquidity pool work?

Technically, liquidity pools consist of cryptocurrency assets locked in smart contracts. How do liquidity pools work? For example on Uniswap, one of the world’s biggest DEXs in terms of market capitalisation, users can select a pair of tokens they wish to provide as liquidity.

They can choose among three tiers of fees depending on the risk of the pool pairs. According to Uniwap, 0.05% fee tier is ideal for stablecoin-stablecoin pairs like USDC-DAI due to their low volatility and minimal risk while the 1% fee tier is designed for high risk exotic pairs, for example ETH-GTC.

Users have to select a price range to provide liquidity for or they can opt to provide liquidity across the full range of prices. The deposit ratio between a selected pair can be adjusted, however Uniswap incentivises users to deposit equal value of both tokens in a pair pool.

“If the price moves outside your specified range, then your position will be concentrated in one of the two assets and not earn trading fees until the price returns to their range,” said Uniswap.

In the event of deposits, liquidity tokens are minted and sent to the provider. The provider must “burn” their liquidity tokens to retrieve their deposited tokens and fees earned from it. Liquidity pool crypto tokens are tradable assets.

Liquidity pools explained: Impermanent losses

According to KPMG, the major levers of liquidity provider returns are divergence losses or impermanent losses and capital efficiency of liquidity provided.

Divergence losses are losses liquidity providers see as their staked paired tokens lose value compared to simply holding individual tokens. This occurs when the ratio of tokens in the pool weighs more heavily towards the lesser value token as the market buys the more valuable token.

Divergence losses are also called “impermanent losses” because losses may be nullified once token prices return to levels when they were staked.

Whereas, capital efficiency refers to trading volume executed against the available liquidity in a pair pool. Larger trading volumes executed against a liquidity pool means higher capital efficiency which results in bigger rewards for liquidity providers.

“Low capital efficiency means that only little trading is executed against capital provided by liquidity providers … Low capital efficiency also implies transaction fees need to be increased, leading to a negative cycle” said KPMG.