Last Update: March 10th, 2022

In the cryptocurrency space, liquidity pools are pools of money that usually contain two pairs of asset classes, similar to Forex pairs. One example is ETH/USDT –  the cryptocurrency Ethereum (ETH) and  USDT – a stablecoin – paired together. These pools are made up of code of smart contracts that automate and facilitate the trading of the two crypto asset pairs. These smart contracts allow traders and investors to trade tokens, even if there are no live buyers or sellers who are willing to purchase or sell at the market price. Liquidity Pools make the flow of money easier and more efficient, through the use of algorithms and smart contracts in the blockchain. Liquidity pools are commonly found in decentralized exchanges or DEXs. 

How are liquidity pools created?

To understand how Liquidity Pools are created, we must first understand how the “Order Book Model” works. This model is the usual way by which traditional finance matches buyers and sellers in the market. 

Order Book Model

There are two columns in the model, one is the “Bid” side and the other is the “Offer” side. The “Bid” side lists all the bidders or the buyers of the asset at their preferred buying price and the number of tokens they are willing to buy. The “Offer” side lists all the offers or the sellers of the asset at their preferred selling price and the number of tokens they are willing to sell. This would then all converge on to a middle point, and if any of the buyers buy up to the “Offer” side, or sellers sell down to the “Bid” side, any match made is a successful trade that is completely executed. The last trade executed is then called the current market price of the asset. The order book model can be seen in all the equity markets and crypto markets as well, especially in the centralized exchanges like Coinbase and Binance. 

Market Makers

However, the use of the model in the financial system can be problematic at times, especially at times when trading is thin, which means there are little to no buyers and sellers in the market. As a result, most order book models rely on what we call “Market Makers.” These are people or institutions that help facilitate trading, as they are always willing to buy and sell any financial asset they are focused on at any price, to essentially “make the market.” This means they are the solution to providing liquidity in an illiquid market. They let buyers and sellers trade faster and more efficiently, as they do not need to wait for another counterpart to buy or sell their bids and offers. The Order Book model works because of these Market Makers; without them, exchanges would definitely face liquidity issues and slippages. 

How it works

Now, on to how Liquidity Pools work. It all begins with what we call “Liquidity Providers” or LPs. These are people who are willing to supply both token pairs (example: DAI/ETH, ETH/USDT) into the liquidity pool. By doing so, they are incentivized to receive interest on their supplied token pairs. In general, when a trade is completed and facilitated by the liquidity pool, they get a small fee for doing so. This adds up to a lot, as there are several trades happening in a day. This fee is then proportionally distributed between the liquidity providers (LP) and the exchange. 

How automated market makers changed the game

Remember that for the Order Book Model to work, they need market makers to help facilitate trading and provide liquidity. In the cryptocurrency world, these market makers are called “AMM” or “Automated Market Makers.” They are automated, using an algorithm, and coded into the blockchain via smart contracts. 

This innovative technology fundamentally makes the order book model obsolete. The inherent process of bidding and offering is still there, but through the AMM, there is no more need for external market makers to create liquidity in the markets. AMMs are connected to the liquidity pools, which then automate the process of market-making. This changed the game because trading in almost any cryptocurrency, be it a small or large token, can be done seamlessly, as long as there is an AMM and a liquidity pool backing it. Traders do not have to take on high slippage or wait for long periods of time just to get matched – everything is automated with AMMs. 

The Impermanent Loss factor

When investing in a Liquidity Pool, it is important to understand the concept of “Impermanent loss” as this can greatly affect an LP’s profits. Impermanent Loss is a temporary loss of value of  the funds you supply in a liquidity pool. 

This happens when an LP provides two assets in equal ratios, but one is a lot more volatile than the other. For example, an LP supplies the DAI/ETH in equal parts. If the ETH price appreciates, the liquidity pool would rely on arbitrage entities to balance it out again, in order to balance the ratios. As such, your ETH profits, due to price appreciation, will be taken away to balance it out with the DAI. In this situation, if you withdrew your assets from the liquidity pool, your ETH would be worth less than the initial deposit. 

On the other hand, if the price of ETH then depreciates to the level that you initially provided liquidity in, arbitrage entities would also balance this out. In this situation, if you withdrew your assets from the liquidity pool, you would come out with the same amount of ETH and DAI that you deposited initially. 

List of Popular Liquidity Pools