How do crypto liquidity pools work?

How do liquidity pools work?

Liquidity is the foundation of both the financial and cryptocurrency markets. Sufficient liquidity in the market is what determines how easily an asset can be bought or sold. 

If liquidity is too low, then it creates difficulty for buyers and sellers to enter or exit positions, and also causes swings in the market with large orders. This also means there is a direct correlation between liquidity and volatility – the more illiquid a market, generally the more volatile it is.

Liquidity in crypto is crucial as a lot of cryptocurrencies generally have lower market volume than a lot of other assets such as large cap equities and currencies. These lower market cap and less traded digital assets are therefore prone to extreme volatility. Where central exchanges can’t always provide sufficient liquidity, a liquidity pool provides a source of liquidity.

If you are looking for a liquidity provider specifically for a crypto exchange, then take a look at our list of the best crypto liquidity providers.

What is a liquidity pool?

Liquidity pools are a huge part of the decentralised finance (DeFi) system. In simple terms, a liquidity pool is a store of cryptocurrency locked into one place. This is to create liquidity, and ensure that transactions are kept relatively smooth. Liquidity providers can be anyone, and in DeFi liquidity pools, liquidity providers can contribute in small or large amounts.

Liquidity is created in the crypto market in multiple ways. A market maker is the most common source of liquidity that works with exchanges, which stand ready to buy and sell crypto assets at any price. Examples of primary market makers in the crypto market are:

• Wintermute
• GSR
• Cumberland
• B2C2

Exchanges such as Coinbase and Binance operate by providing liquidity to members of the exchange with buy and sell orders, and are known as centralised exchanges (CEXs).

These platforms are controlled by a single authority, which is a necessary measure, but some argue is against the spirit of cryptocurrency, which is by nature decentralised and without an owner.

Today, a large amount of cryptocurrency trading operates on decentralised exchanges (DEXs). Uniswap is the largest DEX currently available.

What is a smart contract?

Liquidity pools are held together by what is known as a smart contract.

A smart contract is a program within the blockchain which will run based on predetermined conditions. Essentially, a smart contract is the same as a regular contract but it’s automated, meaning the participants can be immediately assured of the outcome.

In terms of a liquidity pool, a smart contract is agreed to automatically when the users sign up, and will mean that users will automatically stake a portion of their crypto into the liquidity pool, and remove their crypto from the pool when they make a withdrawal.

Why do we need liquidity pools in crypto?

As we have established, low liquidity is bad for an exchange. Even high-volume cryptos such as Bitcoin and Ethereum are prone to wild volatility, so further down the list of cryptos where the liquidity decreases, the volatility can be huge.

Order books are where all the buying and selling transactions are recorded, but due to the limited numbers of buyers and sellers, this can be unstable, and liquidity has to be increased for the risk to become manageable.

Liquidity pools aim to remedy this, particularly for lower volume cryptos. Users are encouraged to become liquidity providers themselves, and provide a portion of their assets to be ‘locked in’ to allow for liquidity in the DEX. 

It also provides security, as a liquidity pool ensures that a sufficient amount of capital is locked in. This means that trades cannot be manipulated as easily, and scams such as rug pulls are far less likely. Communities can also be better created and fostered with a liquidity pool.

How liquidity pools work?

A user will enter a liquidity pool either intentionally as part of a yield farming process, or as a prerequisite for the cryptocurrency.

Entering a liquidity pool will require the user to deposit some of their cryptocurrency into the pool. This is what will create the liquidity for the exchange, and traders will then find buyers and sellers more easily.

In return, liquidity providers will receive a reward such as liquidity pool tokens or a small amount of compound interest, which is known as yield.

Liquidity pool tokens, or LP tokens represent a share of the pool’s overall liquidity, and can even be traded as cryptocurrencies themselves. 

Entering a liquidity pool

Within a liquidity pool, liquidity providers stake a portion of their cryptocurrency into the liquidity pool, and it is locked in by the smart contract.

When a trade is made, the traders will trade directly from the pool, essentially forming the DEX. Traders then exchange on the DEX, which is controlled by the liquidity pool.

Here is a slightly more detailed diagram:

The market is kept stable with liquidity provided by the users. This is where automated market makers (AMMs) come along. These work by automatically calculating the price of the assets in the pool based on the demand and adjusting the price in real-time.

Exiting a liquidity pool

Exiting a liquidity pool is simple. All a liquidity provider will need to do is sell their cryptocurrency, and therefore their stake in the liquidity pool. They will need to exchange or ‘burn’ their LP tokens in order to receive their assets back.

However, due to the compounding benefits of remaining within a liquidity pool (yield farming), there is an incentive to stay within it for as long as possible. 

Each time a cryptocurrency is bought or sold, liquidity providers will be given LP tokens. LP tokens represent shares of the liquidity pool but have many other uses, not just monetary returns. For example, LP tokens can also provide users access to certain crypto loans, and also give the users voting rights in some cases on changes to the cryptocurrency.

Conclusion

Liquidity pools are a key part of DeFi, and as cryptocurrency becomes more popular, as will liquidity pools and DEXs.

At LiquidityFinder, we host a wide range of liquidity providers including crypto exchange providers.

Register with LiquidityFinder in minutes, and you’ll join our exclusive network of liquidity providers, as well as gain access to tools such as our Match Matrix and our multi-provider request form.

Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder. You can message Caleb here.