How do trades work in traditional finance?
Before delving into how crypto liquidity pools work, we need to examine how traditional financial markets match buyers with sellers.
Have you ever wondered why you can trade on exchanges instantly? Every trade requires an entity on the other side, but there always seems to be one available. Most often this entity is a market maker. Centralized markets rely heavily on entities known as market makers to ensure traders always fill their orders.
Market makers hold massive positions in assets like stocks that they make available to traders. The price at which market makers are willing to buy assets is known as the bid price, while the price at which they are willing to sell them is known as the ask price. To ensure a profit, market makers build in a slight price divergence between the bid-ask price (or bid-ask spread).
Because market makers have a huge supply of assets, they help trading platforms match buyers and sellers in a timely manner. The liquidity that market makers provide ensures that traders always close their trades at the agreed price. In contrast, illiquid markets often suffer price slides due to a lack of readily available securities. “Slippage” refers to a significant change between the quoted and actual price of an asset. By the time a trade is closed in an illiquid market, there is a chance that the price will differ from what traders expected to buy or sell their investments.
In traditional finance, market making is a closed system open only to wealthy individuals, firms and corporations. Citadel Securities and Virtu Financial are some of the most prominent market makers in the US stock market (at the time of writing).
What is a liquidity pool in crypto?
A liquidity pool (crypto) serves the same purpose as market makers, but they eliminate the centralized hierarchy of traditional finance. Rather than relying on third parties like Citadel, decentralized exchanges (DEXs) allow anyone to “pool” their crypto on one platform for easier trading.
Liquidity pools rely entirely on code-based programs known as smart contracts. Blockchains like Ethereum use smart contracts to execute commands without third parties. Once the conditions of a smart contract are met, it should automatically fulfill its program. For example, if a smart contract is set to release your collateral when you have repaid a crypto loan, it will do so after determining the final interest payment.
These large funds provide DEXs with the crypto liquidity they need to allow other users to trade tokens without relying on outside firms or large investors. People with a private crypto wallet and cryptocurrency can add their tokens to these logs. In return, they are rewarded with a portion of the trading fees. Web3 developers hope this new decentralized system will democratize the trading experience for average investors.
How do liquidity pools work?
Liquidity pools run on smart contract code. While there are many algorithms that a DEX can use to create its liquidity pools, the most popular is the “x*y = k” formula. In this algorithm, “x” and “y” refer to the two tokens in the liquidity pool, while “k” is a constant value. Because “k” must remain consistent, the DEX constantly adjusts the distribution of “x” and “y” tokens to keep them evenly split. DEXs like Uniswap, SushiSwap, and PancakeSwap use this algorithm to balance the tokens in their liquidity pools.
In addition to smart contract algorithms, liquidity pools rely on arbitrage traders to ensure that the quoted price of a digital asset is correct. Arbitrage is a strategy in which traders profit from a slight deviation in the price of a token between two exchanges. If arbitrage traders find that a token’s price is slightly lower on a DEX than on a centralized exchange (CEX), they will likely buy the asset on the DEX and quickly sell it on the CEX.
But what is the point of arbitrage between liquidity pools? This trading strategy will apply the necessary buy or sell pressure to the deposited tokens, which is intended to balance the tokens in a liquidity pool.
In addition to arbitrage and algorithms, liquidity providers (LPs) are vital to liquidity pools. LPs are individuals who deposit their crypto into a liquidity pool. Because LPs provide the tradable assets on a DEX, they are on par with market makers in traditional financial markets. Remember that anyone can contribute their crypto to a DEX’s liquidity pool if they have a private crypto wallet and the required tokens.
What are Liquidity Pool Tokens?
One may wonder why anyone would voluntarily include their cryptos in a DEX’s liquidity pool. Besides supporting decentralized crypto trading, what benefits can LPs expect?
With most DEXs, LPs receive a portion of the total trading fees for each token pair they contribute. For example, Uniswap has a flat trading fee of 0.3% that is constantly spread across all LPs. The number of tokens you contribute to a liquidity pool determines the token rewards you receive for each swap.
LPs can also get bonus token rewards depending on which DEX they are on. Most DEXs have governance tokens built into their reward structure. These governance tokens not only serve as bonus incentives, but give holders a vote on proposed upgrades to a DEX. Some prominent tokens issued by DEX are Uniswap’s UNI, PancakeSwap’s CAKE, and SushiSwap’s SUSHI.
How have liquidity pools revolutionized finance?
Liquidity pools offer a novel solution to provide secure crypto liquidity in DeFi (decentralized finance). Autonomous smart contracts, open-source code, and easy access to average investors can reduce the power and influence of centralized market makers. Liquidity pools provide crypto investors with an easy, trusted way to trade or deposit funds for passive rewards.
Although the total value locked in liquidity pools (TVL) has increased since Uniswap launched in 2018, keep in mind that it is still in the early stages of development. CEXs like Binance still offer far greater liquidity to crypto traders.
However, as the DeFi sector grows, liquidity pools will offer a new market-making model. It’s not just DeFi-specific tokens that may be available for trading. In the future, more DEXs could offer security tokens representing synthetic stocks, ETFs (Exchange Traded Funds) and precious metals. As liquidity pools and DEXs become more mainstream, centralized markets can have less impact.
Security considerations in liquidity pools
As exciting as liquidity pools are, there are risks associated with depositing funds into these smart contracts. People need to review general LP risks to manage their crypto portfolios.
A major problem in becoming an LP is a phenomenon known as inconsistent loss. Remember that liquidity pools are constantly adjusting to receive an equal share of tokens. As digital asset prices change, so does the balance of your crypto in the liquidity pool. Volatile loss refers to “losing” gains greater than simply holding a cryptocurrency.
For example, you deposit 1 ETH and 2,000 USDT into a Uniswap ETH/USDT pool. Uniswap’s liquidity pools require LPs to deposit a 50/50 split of tokens. So, at this point, 1 ETH equals 2,000 USDT.
Let’s also assume that 50 ETH and 100,000 USDT are in this pool when you provide liquidity. This means you own a 2% share of the liquidity pool and the constant “k” value is $200,000.
Should the price of ETH explode to 4,000 USDT, the total ETH balance in that pool would drop to 25 ETH as arbitrage traders balance the liquidity pool. If you withdraw your tokens now, you would have half the ETH you originally deposited. While your 0.5 ETH is still 2,000 USDT, if you were just holding the 1 ETH it would have been worth double that.
Note: This example does not take into account all of the token rewards you would earn during this time. Also, this example assumes that nobody else is adding liquidity to your pool.
Alongside the risk of fickle loss, new LPs need to remember that DeFi is an unregulated space. There’s no insurance coverage for DEXs, so there’s a tiny chance you could lose all your money if there’s a hack or bug in the smart contract code.
Currently, many experts recommend sticking with the most well-known DEXs and prioritizing dApps (decentralized applications) with high TVL and a long track record. Some of the most well-known DEXs are (at the time of writing):
- Uniswap
- curve financing
- pancake swap
- equalizer
Wrap up
Liquidity pools are a giant leap forward in the DeFi ecosystem. Should liquidity pools gain in importance, they can examine the influence of centralized market makers on trading platforms. Although smart contract technology is still in its infancy, liquidity pools appear to be a promising tool for democratizing global traders.
Speaking of “democratizing crypto”, we at Worldcoin want to bring the possibilities of Web3 to the globalized economy. Our goal is to put a piece of our crypto into the hands of every person on the planet for free. Subscribe to our blog to find out more.
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