Dubai, UAE, 19th December 2023, Throughout the history of the cryptocurrency industry, liquidity has been a topic of intense discussion, with numerous debates surrounding the associated challenges and potential solutions. This issue has been particularly contentious within the DeFi sector, as it has long been in competition with centralized exchanges (CEXes) and other centralized solutions for users. These users were initially drawn to CeFi for various reasons, including accessibility, making it difficult for DeFi to attract and retain them.
Liquidity pools were created to overcome the limitations of order books, which are almost exclusive to centralized platforms. The order books consist of buy and sell orders, and centralized exchanges employ market makers to ensure sufficient liquidity at any point. This approach has been criticized for inefficiency, centralization, and the power it gives to exchanges as middlemen between users.
The model using automated market makers (AMMs) and liquidity pools was developed to maintain the main crypto principle during trading: decentralization. Such an approach enables a steady swapping experience that relies less on other traders because it utilizes assets provided by crypto holders instead. As a result, it allows for trading or, in the case of lending protocols, lending 24/7.
With advances in the DeFi industry’s developments, liquidity pools evolve too. For example, some projects are building multi-token pools that can simultaneously hold more than one pair.
Maintaining Pool Balance
The constant observation and balance maintenance of liquidity pools is crucial, which is where AMMs come in. Initially, each liquidity pool begins with a predetermined asset ratio, and users must deposit funds in a specific proportion to not destroy it.
AMMs use specialized formulas that ensure asset prices stay balanced by adjusting the ratio of the two assets as users trade against the liquidity pool. This automatic price adjustment helps maintain liquidity and reduce possible slippages.
Such formulas can vary depending on the project’s goals and market conditions. This flexibility is necessary as market conditions and user behavior tend to change a lot, occasionally leading to significant pool imbalances. In these cases, AMMs must be able to adjust quickly by, for instance, relocating liquidity to different pools or optimizing pools in other ways to adapt to ever-changing market demands.
The smooth functioning of liquidity pools depends on two key components: AMMs, which we touched upon earlier, and liquidity providers. As the name suggests, the latter refers to individuals or entities providing liquidity, mainly to pools.
Liquidity providers play a crucial role in maintaining the pool operation and bear all the risks associated with changes in asset prices, such as impermanent loss. Therefore, projects must offer different incentives, including LP tokens or a share of trading fees, to encourage them to place their assets in pools despite all potential risks.
Role in DeFi
Liquidity pools enable users to swap crypto assets quickly and around the clock, regardless of the demand for particular assets or active hours, which affect trading on some centralized exchanges.
From the providers’ point of view, liquidity pools are very advantageous, too, as they provide opportunities for passive income. By participating in the provision of liquidity to pools, also called yield farming, individuals can sustain cryptocurrency trading across networks and make a profit.
Lastly, liquidity pools have a significant role in supporting lending protocols that allow borrowers to access crypto assets they require and lenders to earn from lending their assets. By consolidating funds from various parties, liquidity pools allow traders without considerable funds to engage in trading, promoting the overall development of the DeFi industry.
Liquidity pools are an integral part of the DeFi ecosystem and play a critical role in enabling a wide range of financial transactions, including lending, borrowing, and trading. However, despite their benefits, liquidity pools can also pose notable risks, such as frequent hacker attacks or impermanent losses. These risks can result in substantial financial losses for users, which is why many DeFi projects, including Kinetex, are actively researching and developing methods to mitigate these risks and eliminate vulnerabilities associated with liquidity pools.
Disclaimer: The views, suggestions, and opinions expressed here are the sole responsibility of the experts. No Market Encore journalist was involved in the writing and production of this article.