What are Liquidity Pools?

Liquidity Pools are the trading component of a decentralized exchange. Like order books, they are the matching engine, but they also function as market makers. Their role is to increase market liquidity between market participants.

In the DeFi space there are currently two types of decentralized exchanges:

• Order Book Exchanges - such as 0x and Radar Relay
• Liquidity Pool Exchanges - such as Kyber, Uniswap, and Curve Finance

Order book exchanges

Order book exchanges rely on a bid/ask system to fulfill trades. Orders get routed to an order book when a new buy or sell order is created. Then the exchange’s matching engine executes matching orders of the same price.

The system works well when there is enough liquidity in the market. But, crypto tokens create a unique set of challenges. Most crypto tokens lack trading volume and liquidity. It may be very difficult for a trader to trade into or out of a particular token. This is due to a lack of trading volume and liquidity. Also, large trades of any particular token, may swing the price of a token. Thus, creating signifiant slippage for the trader. As such, tokens have been characterized as a very volatile asset class.

Liquidity pool exchanges

Liquidity pools offer a solution to the problem. They remove the exchange’s dependence on order book trading. Enabling the exchange to ensure a constant level of liquidity.

The following are the main advantages of liquidity pool exchanges:

Liquidity at every price level

In short, a liquidity pool is an automated market maker built with smart contract code. The code facilities both buy and sell orders on a set of predefined parameters. A counter party is no longer needed for trades. As long as the pool contains enough assets to cover the trading volume, an order book system is not required. To note, price slippage can occur when trades are larger than the pool size can handle.

Passive Market Making

When using a traditional order book, market makers need to constantly adjust their bid-ask spread as the prices change. This process can take a significant amount of time and expertise. Generally, professional traders only have the resources to actively engage in market making. Liquidity pool providers can earn yield by deposing their assets into the pool. The smart contract code then facilitates all the market making activity.

Open Market Making

Participants of liquidity pools today need no fee to take part and no KYC. Anyone with an asset can lend their tokens to a liquidity pool and start to earn yield on their deposits.

How to participate in a liquidity pool?

Supplying $50 of liquidity into an ETH/USDC pool requires a deposit of $50 worth of ETH and $50 USDC. A total deposit of $100 is required in this example. In return, the liquid provider will receive liquidity pool tokens. These tokens represent their proportional share of the pool and allows them to withdraw their share of the pool at any time.

When a trader places a trade, a trading fee is deducted from the trade and the order is sent to the smart contract containing the liquidity pool.  For most decentralized exchanges the trading fee is set at 0.3%. In our example, if you deposit $50 ETH and $50 USDC and your contribution makes up 1% of the pool. For any particular trade you will receive 1% of the 0.3% trading fee.

How are assets priced?

Liquidity pools are designed to execute trades and also maintain a market price. Pool reserves stay constant despite the additional trades. Buy transactions will increase the price of the bought asset relative to the asset sold. Since the bought asset’s ratio of the pool decreases. Sell transactions decrease the price of the asset sold. Since the ratio of the pool increases.

How much yield can a liquidity provider earn?

The performance of the pool depends of the following factors:

1. The asset price when the tokens are deposited and withdrawn
2. The total liquidity provided by the pool
3. The trading volume of the pool

A word of caution, trading activity will change the asset price and quantity of assets in the pool. Investors will likely end up withdrawing a different ratio of assts. This may be different than the ratio of assets that was first deposited into the pool. The price change in the market may work for or against you. Impairment loss is the DeFi nickname for this type of risk. Finally, realized returns may also fluctuate. This depends on the price of assets in the pool, the ratio of the pool, and total earned trading fees.