Centralized exchanges like Bitstamp, match buyers and sellers (traders), who transfer assets based on an agreed-upon price. This model is called an order book, because all orders and their prices are recorded one-by-one on a list.
Blockchain technology’s use of smart contracts introduced another model for swapping between assets, called automated market makers (AMMs). Liquidity pools are a crucial part of this process. Breaking down the term: liquidity refers to assets available to trade on the market, and pools are collections of crypto coins/tokens that are grouped together.
Many decentralized exchanges use liquidity pools as collective sources of assets with which traders can interact. This functionality is one of the main drivers of the expansive decentralized finance (DeFi) ecosystem.
How do liquidity pools work?
Although there are many complexities to liquidity pools, its basic function is relatively simple. Let’s use an example of a pool that contains ETH and USDC.
Liquidity providers (LPs) lock an amount of ETH and USDC in a dedicated smart contract that holds the assets (the pool). Other users who want to swap between ETH and USDC dip into the liquidity pool as a source of assets. For instance, one might deposit some ETH into the pool and receive an equivalent value of USDC (or vice versa).
The swappers pay a small fee for using the pool, and this fee is distributed among the LPs to incentivize them for the service they provide. Generally, LPs are issued another cryptocurrency called LP tokens that give them the right to collect a percentage of all fees that is proportional to the amount of liquidity they provide to the pool. In other words, the more assets LPs lock up, the more LP tokens they receive, and the higher proportion of fees they collect.
Although this basic mechanism powers all liquidity pool-based swaps, there are many variations. Some platforms, for instance, offer the ability for liquidity providers to stake their LP tokens and generate additional rewards. This is one form of a popular practice in DeFi called yield farming.
Automated market maker
The platforms that use liquidity pools to power digital asset swaps are called automated market makers (AMMs). AMMs are smart contract-based protocols that dictate how LPs, liquidity pools, LP tokens, and other related functions work together.
One important function of an AMM is ensuring that asset valuations remain accurate, so users making swaps are not losing (or gaining) value compared to market prices of their crypto. One way they do this is stabilizing asset prices according to their fluctuations within a liquidity pool. In the above example of an ETH/USDC pool, this means that as ETH is deposited and USDC is withdrawn, the total quoted price of ETH decreases and USDC increase, thus leaving a constant total value in the pool. The math behind this rule is called the Constant Product Formula.
In order to maintain price stability, AMMs also rely on 1) arbitrage traders who trade across markets to take advantage of differences in prices, and 2) oracles, which are tools that communicate real-world information to blockchain-based systems.
Decentralized exchanges that use liquidity pools
Some of the most popular AMM-based DEXs that use liquidity pools are:
- Bancor – DEX protocol that invented the AMM model in 2017. It uniquely matches user deposits by contributing its native BNT token in every liquidity pool, allowing users to make single-sided deposits (i.e. provide liquidity using one token rather than two).
- Uniswap – popularized the AMM model and is deployed on Ethereum, the Polygon sidechain, and layer 2 solutions like Optimism and Arbitrum.
- Curve – focuses on hosting pools of stablecoins with the aim to help investors participate in providing liquidity without having to contribute more volatile assets.
What are the benefits and risks of using liquidity pools?
AMM-based liquidity pools use automated, blockchain-powered technology where users can swap digital assets without relying on centralized entities. Rather, using liquidity pools relies on trusting publicly available code.
However, because liquidity pools are subject to strict rules coded into smart contracts, they also may be subject to exploits by hackers if that code has vulnerabilities.
Another risk of using liquidity pools is impermanent loss, which can happen when the two assets deposited in a pool lose value due to market conditions, or the swaps themselves. The loss is called “impermanent” when the assets remain in the pool, but these become permanent, realized losses if/when the user removes their funds from the pool.
Liquidity pools essentials
- Liquidity pools are collections of different cryptocurrencies that are used by traders wishing to swap between assets.
- Liquidity pools rely on the interaction between liquidity providers (LPs) who lock their crypto in smart contracts and users (including arbitrage traders) who swap their crypto using the locked funds for a fee paid back to LPs.
- The automated market maker (AMM) model that uses liquidity pools was introduced by the Bancor decentralized exchange and popularized by Uniswap.