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What Is a Liquidity Pool in Cryptocurrency?

By Brian Nibley · July 18, 2022 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What Is a Liquidity Pool in Cryptocurrency?

A liquidity pool is a collection of cryptocurrency funds grouped into a smart contract. This smart contract provides users of decentralized exchanges (DEXs) with access to liquidity for their trades. Rather than traditional order books containing buy and sell orders, most DEXs use automated market makers (AMMs) to facilitate trades automatically via liquidity pools.

Continue reading this crypto guide to learn about the innovation of liquidity pools and their various use cases.

How Crypto Liquidity Pools Work

Liquidity pools offer incentives to investors in exchange for locking up tokens in the pool. Most often, incentives come in the form of trading fees from the exchange that utilizes the pool. When someone provides liquidity to a pool, they might gain a liquidity provider (LP) token for doing so. The tokens themselves can be valuable, but also have other functions inside the decentralized finance (DeFi) ecosystem.

Those who provide liquidity typically receive a number of LP tokens proportionate to the amount of funds they have given to the pool. Each time a trade is facilitated using that pool, a portion of the trading fee is divided up and given to those who hold LP tokens.

When someone buys a token on a decentralized exchange, they aren’t buying from a seller in the same way that traditional markets work. Instead, the trading activity is handled by an algorithm that controls the pool. AMM algorithms also maintain market values for the tokens they hold, keeping the price of tokens in relation to one another based on the trades taking place in the pool.

The finer points of just how liquidity pools work is a highly technical topic that branches out into numerous subtopics , which are worth taking the time to understand.

The Importance of Crypto Liquidity Pools

In the beginning, DEXs often had liquidity problems. They tried to mimic traditional exchanges with order books, and this didn’t work very well. At some point, the invention of a liquidity pool was introduced, giving users an incentive to provide liquidity and removing the need to match buyers with sellers using an order book.

This one change helped enable DeFi’s explosive growth of over the last several years, as it gave decentralized exchanges a way to provide liquidity using crowdfunded pools and algorithms.

Purpose of Liquidity Pools in DeFi

The main purpose of a liquidity pool in DeFi is to facilitate transactions without a centralized third party. Through the use of automated market makers (AMMs) and liquidity pools, trades can be executed automatically thanks to the pool. There’s no need for order books containing countless buy and sell orders.

Liquidity pools can also be used for a variety of other purposes, which include:

•   Tranching: dividing up financial products according to risk/reward profiles;

•   Minting synthetic assets, and

•   Providing insurance against smart contract risks.

Another use of liquidity pools involves what’s known as yield farming, which we’ll explain in more detail shortly.

Liquidity Pool Comparisons

What is a liquidity pool in comparison to other, similar DeFi alternatives?

Yield farming is a practice involving the use of multiple liquidity providers in a way that can maximize yield. Staking crypto works much the same way as participating in a pool, although the process may be different.

Liquidity Pools vs Yield Farming

Some DeFi platforms offer additional incentives for users to lock up tokens in the pool. This can be done by providing more tokens for special “incentivized” pools. Being a participant in these pools and getting as many LP tokens as possible is known as liquidity mining.

With a variety of different platforms and liquidity pools available, it can be difficult to determine where the best place to put one’s crypto might be. Yield farming involves locking up tokens in different DeFi apps in such a way as to maximize potential rewards.

Some platforms, like Yearn.finance, can automatically move user funds to different DeFi protocols in accordance with a user’s preferred risk tolerance and desired reward.

Liquidity Pools vs Staking

Staking and using a liquidity pool function in much the same way. In both cases, users lock up tokens and earn rewards. But what’s going on “under the hood” is a much different story.

While liquidity pools are a function of decentralized finance, staking simply involves dedicating tokens to a particular proof-of-stake (PoS) network. Holders of PoS tokens cam elect to lock up some of their funds to help validate transactions on the network. In exchange, they get a chance to earn the next block reward of newly minted coins.

Potential Benefits and Risks of Liquidity Pools

It’s important to look at the risks and benefits when trying to answer the question “what is a liquidity pool.” In general, the risks are numerous, and the big benefit comes in the form of substantially higher yields than those in most traditional markets.

Potential Benefits

The main benefit of crypto liquidity pools is the potential to earn a yield on crypto that would otherwise be idle. With interest rates at historic lows, some investors have begun looking beyond traditional products like certificates of deposit (CDs), Treasury bonds, and savings accounts for yield. There are stories of people achieving astronomical yields on their crypto with various DeFi products, although there are just as many stories of people who’ve invested in crypto products and lost everything.

Potential Risks

DeFi might be among the riskiest ventures in crypto. The smart contracts that underlay these platforms sometimes have exploitable bugs in them. Because of the large profit opportunity, these protocols have become a prime target for hackers.

In addition to hacks, some DeFi projects have proven to be outright scams from the start. A “rug pull” is a common type of scam in this area. Rug pulls involve developers creating a project, attracting investor funds, and then shutting down operations while making off with everything people had deposited. Consumers often have no legal recourse in these cases, and tracking down the perpetrators can be difficult, if not impossible.

Investing in DeFi products that use crypto liquidity pools involves the potential for total loss of principal.

The Takeaway

The answer to the question “what is a liquidity pool” gets complicated in terms of the technical aspects. In a nutshell, liquidity pools are crowdfunded pools of crypto used to facilitate trades and perform other functions in DeFi. This method of financing operations has made possible a number of innovative decentralized financial services.

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FAQ

What does a liquidity pool do?

A liquidity pool provides liquidity for decentralized exchanges. Most often, liquidity pools are used to facilitate trades in a decentralized manner, although liquidity pools can also be used for other purposes like insurance, tranching, or minting synthetic assets.

How do liquidity pools make money?

Those who provide liquidity to liquidity pools receive tokens that divvy out rewards that come from trading fees. The rewards are proportional to the amount of value locked into the protocol.

How do you participate in liquidity pools?

Participating in crypto liquidity pools requires participating in decentralized finance. This typically involves creating an account on a decentralized exchange, exchanging a token you have for an LP token, and locking up the token in the platform. Most platforms have simple user interfaces that guide users through the process.


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