The Importance of Liquidity Pools in DeFi

Decentralized finance (DeFi) has, without a doubt, changed the face of the cryptocurrency landscape. Once a Wild West of protocols and digital assets with arguably dubious or limited utility, DeFi has positioned cryptocurrencies and blockchain technology as a true competitor to traditional financial infrastructure.

Indeed, the total value locked (TVL) in DeFi platforms has exploded over the last three years, climbing from $467,000 at the start of 2019 to over $240 billion three years later. Likewise, there are now more than 100 DeFi-capable chains in operation, 15 of which have a TVL in excess of $1 billion.

These figures put the current DeFi landscape on par with a top 20 US bank with more than 20x further growth still needed for the DeFi TVL to match the total holdings of the US’ largest bank, JPMorgan Chase.

This considerable growth would not have been possible without the innovation of decentralized liquidity pools — which are an assortment of (typically) user-contributed assets locked up in and controlled by smart contracts, for use by a specific application.

What are Liquidity Pools?

Today, practically every major decentralized exchange (DEX) supports permissionless liquidity pools — which are a collection of user-contributed digital assets that are controlled by a smart contract.

Liquidity pools are created when users deposit their assets into an address controlled by a smart contract. These assets are typically used to provide liquidity for trades on an associated decentralized exchange — allowing users to trade by drawing liquidity from one side of the pool and adding it to the other.

The users who have deposited their assets into the pool receive a share of the pool’s revenue in proportion to their contribution. This is usually in proportion to their share of the pool, such that a user that contributed 10% of the assets in a pool would receive 10% of the fees it generates. They also receive a number of LP tokens, which represents their share in the pool, and can be either transferred to other users (like any regular token) or redeemed to retrieve some or all of the assets they provided as liquidity.

In most cases, liquidity pools contain two assets, each of which forms one side of the pool. The value of each side of the pool is always considered equal, such that if you had 1,000 USDC and 1 ETH in the liquidity pool, then the value of 1 ETH is exactly 1,000 USDC. As liquidity is added to/withdrawn from each side of the pool, this weighting would change, thereby changing the relative values of the two assets in the pool.

Below, we show how three transactions, each withdrawing half of the available ETH liquidity would affect the weighting of a pool.

As you can see, since the value of both sides of the pool remains constant, withdrawing from one side of the liquidity pool (and simultaneously adding to the other) can lead to rapid changes in asset pricing. Note that this is a simplified pool that has one stable side (USDC) and one volatile side (ETH) and is an example of a constant product pool — since the sum of both sides of the liquidity pool always remains constant.

That said, there are now a wide variety of different pricing curves supported by different AMMs, including Curve’s Stableswap mechanism and fixed swap mechanisms (constant price invariant). This enables a variety of additional use cases, including ultra-low slippage and low fee swaps (ideal for stablecoin swaps) and fixed-rate swaps.

Liquidity pools are a key part of decentralized finance (DeFi) and have been used to provide liquidity for a variety of different assets, including cryptocurrencies, stablecoins, and even traditional assets such as gold. They’re also being used outside of decentralized exchanges for a growing number of novel use cases.

Why Are They Important?

Decentralized liquidity pools are widely considered to be one of the most important breakthroughs in the development of decentralized financial (DeFi) applications — since they allow essentially anybody to contribute liquidity to both up-and-coming and already established protocols, eliminating the liquidity concerns that early DeFi protocols often faced.

Rather than relying on centralized market makers, these liquidity pools help to increase decentralization in the DeFi space, and better balance incentives among its participants by rewarding LPs for supplying liquidity while maximizing orderbook depth to minimize slippage — ensuring traders get a better bang for their buck.

Decentralized liquidity pools now help to power a wide variety of DeFi tools and platforms, many of which fall under one of the following umbrellas:

  • Automated market makers: Decentralized exchanges like Uniswap, Curve, and PancakeSwap popularized decentralized liquidity pools, where anybody can provide the liquidity that traders can use to complete their token swaps. Without these liquidity pools, AMMs would be relegated to using centralized liquidity providers or suffer from low liquidity, defeating their purpose as decentralized exchanges.
  • Cross-chain bridges: Cross-chain bridges are increasingly turning to decentralized liquidity pools as a way to maximize liquidity for cross-chain asset transfers while boosting the utility of idle assets. Indeed, platforms like zkLink and ChainSwap allow users to contribute their assets to the protocol’s liquidity pools and earn a fraction of the cross-chain fee in return.
  • Open lending protocols: The last few years have seen the advent of a variety of open lending protocols like Compound and Aave which use decentralized liquidity pools and smart contracts to automatically provide collateralized loans to borrowers and share any interest among liquidity providers. This enabled the first wave of decentralized competitors to platforms like Nexo and Celsius, and many open lending protocols now form a crucial part of additional DeFi infrastructure — including yield aggregators like Autofarm and yield optimizers like Yearn Finance.

Liquidity pools help ensure that DeFi applications run smoothly and remain as decentralized as possible, while allowing token holders to extract additional utility and yields from their tokens, without needing to sell them. Because of this, a growing proportion of cryptocurrency holders now provide liquidity to one or more DeFi platforms.

The Dangers of Impermanent Losses

Permissionless liquidity provision has, without a doubt, been one of the biggest innovations in the blockchain industry in recent years — and has unlocked a huge array of novel use cases, increasing utility for token holders, and helping to improve decentralization in the industry.

But there is one frequently overlooked challenge that many users get stung with — impermanent losses. These are the potentially temporary losses that liquidity providers can face when the ratio of the value of their deposited tokens begins to deviate. This can cause the weightings to change unfavorably, leaving the user with less money than they would have had if they had simply held on to their assets rather than depositing them as liquidity.

Consider the following simplified example:

Imagine a liquidity pool that contains 1,000 USDC and 1 ETH, such that 1 ETH is worth 1,000) USDC. If a liquidity provider contributed 20% of this pool, this would mean their contribution is worth 200 USDC and 0.2 ETH (for a total value of $400) at the time of the pool’s creation.

Now, if Ethereum climbs in value on an external platform and becomes worth, say 4,000 USDC, this exposes an opportunity to arbitrageurs, who will seek to withdraw ETH from the liquidity pool at the 1 ETH = 1,000 USDC rate, to sell it on external exchanges for a profit. In doing so, they will reduce the amount of ETH left in the pool and increase the amount of USDC.

Eventually, the arbitrage opportunity will be closed when there is no longer a discrepancy between the price of ETH available in the pool and on external exchange platforms. At this point, the weighting of the two assets in the liquidity pool will change such that 1 ETH = 4,000 USDC. Since the total sum of tokens must remain constant, this means there would be 0.25 ETH and 4,000 USDC in the pool.

Since the liquidity provider still owns 20% of the liquidity pool, they could then withdraw their assets, which would leave them with 0.05 ETH and 800 USDC, for a total value of $1,000 — equivalent to $600 in profit.

However, had the liquidity provider simply held on to their assets, they would have had 400 USDC + 0.2 ETH (which would have multiplied in value from $200 to $800), yielding a total of $1,200 — or $800 in profit.

This potential loss of $200 in profits is known as impermanent losses and is considered impermanent since the user only locks in this loss once they withdraw their liquidity. Since the weightings could potentially return to 1 ETH/1,000 USDC (e.g. if ETH loses value or USDC gains it), the impermanent losses would be neutralized.

Nonetheless, a recent study indicates that just under half of liquidity providers are in a net loss since their fee revenue was insufficient to compensate for ILs.

Image courtesy: Topaze Blue

Sum ILs exceed sum fees for the vast majority of Uniswap V3 liquidity pools.

Users that provide liquidity to pools containing one or more volatile assets are most vulnerable to impermanent losses since the ratio of the assets is likely to deviate at some point. Because of this, users need to be sure that the yields they earn from being a liquidity provider exceed any potential losses that can come by actualizing ILs by withdrawing their liquidity.

That said, platforms that offer fixed-rate swap pools avoid this challenge, but do not benefit from the ultra-efficient price discovery that the constant product formula provides.

There are a number of tools that can be used to predict and stay on top of impermanent losses. These include CoinMarketCap’s simple impermanent loss calculator and the data analytics platform APY Vision.

The Role of Yield Farms

The advent of liquidity pools enabled the creation of various other pieces of DeFi infrastructure, including automated market makers, open lending platforms, and cross-chain bridges. They also allowed for the creation of a new type of reward solution, known as a yield farm.

Yield farms are platforms that allow users to maximize the returns on their capital by staking their liquidity provider (LP) tokens. By doing so, the user not only earns the standard cut of the fees from the liquidity they provided, but also an additional yield from a separate rewards pool — usually in the form of a separate token.

For example, a user that contributes liquidity to the BNB/USDT pool on PancakeSwap could then stake their BNB/USDT LP tokens in one of the platform’s yield farms to earn additional rewards in CAKE tokens.

Though users benefit by earning a yield on their assets, project owners and yield providers benefit in two main ways:

  • Increased exposure: Yield farms are a way to expose liquidity providers to new projects that might interest them. In turn, some of these users will likely go on to invest in the project token, helping to support its value, and may even become liquidity providers — helping to maximize liquidity for the token. Project tokens that offer a high yield can attract significant press coverage, word-of-mouth, and KOL marketing, helping to further grow its userbase. That said, if this high yield causes excess supply, it can have detrimental effects on the token’s valuation — this is extremely common.
  • Wider distribution: Many projects are looking to increase the number of token holders, both in order to reduce centralization, and to later convert as many of these holders to product users as possible. Yield farms can allow a project to distribute its tokens to potentially tens of thousands of active users with ease. This is particularly important where the reward token is used for governance since it can increase community participation and reduce the chances of monopolization.

That said, if the yield farm fails to generate positive momentum for the project, it can also be counterproductive — increasing selling pressure and making the token less desirable for potentially interested investors/users. This is doubly true for tokens that lack burn mechanism or utility.

Image courtesy: PancakeSwap

Striking a balance between attractive yields and long-term sustainability is a continual challenge for many projects that provide a yield farm.

Yield farms can be offered by both centralized and decentralized exchanges, and a wide array of independent projects now offer their own yield farms.

Conclusion

Without liquidity pools, DeFi as we know it simply wouldn’t exist. As such, it isn’t an understatement to say that much of today’s DeFi infrastructure relies on the existence of liquidity pools.

As a crucial piece of financial infrastructure, liquidity pools are likely to continue to gain momentum and provide an increasingly competitive environment for DeFi protocols — helping to push innovation and better match or exceed the capabilities of centralized platforms.

For decentralized finance to continue to gain momentum, more critical pieces of financial infrastructure need to be moved away from centralized liquidity sources. This will likely begin with insurance providers, venture funds, and charity organizations, which will soon be able to leverage decentralized liquidity pools to increase inclusion and boost efficiency.

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About Master Ventures

Master Ventures is a blockchain-focused venture studio helping to build the next generation of blockchain-based Web 3.0 system innovations within the crypto industry. Launched in 2018 by Founder and CEO Kyle Chassé, the company’s ethos can best be summarized in the acronym #BeBOLD: Benevolent, Open, Love, Decentralized.

Master Ventures co-creates with entrepreneurs and businesses worldwide to turn the best ideas into innovative and disruptive products. They do this by investing as strategic partners through offering advisory services to the projects they believe in. To date, Master Ventures has invested in over 40 crypto projects, including the likes of Kraken, Coinbase, Bitfinex, Reef, DAO Maker, Mantra DAO, Thorchain, and Elrond.

For any questions, please feel free to reach out to us on:

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