The world of finance runs on liquidity. Without available funds, financial systems grind to a halt. DeFi, or decentralized finance — a catch-all term for financial services and products on the blockchain — is no different.
DeFi activities such as lending, borrowing, or token-swapping rely on smart contracts — pieces of self-executing codes. Users of DeFi protocols “lock” crypto assets into these contracts, called liquidity pools, so others can use them.
Liquidity pools are an innovation of the crypto industry, with no immediate equivalent in traditional finance. In addition to providing a lifeline to a DeFi protocol’s core activities, liquidity pools also serve as hotbeds for investors with an appetite for high risk and high reward.
How liquidity pools work
Look beyond the technical language and you’ll find that the basic rationale of liquidity pools is intuitive. For any economic activity to happen in DeFi, there needs to be crypto. And that crypto needs to be somehow supplied, which is exactly what liquidity pools are set to do. (That role is fulfilled by order books and market markers on centralized exchanges, but that’s a different story.)
When someone sells token A to buy token B on a decentralized exchange, they rely on tokens in the A/B liquidity pool provided by other users. When they buy B tokens, there will now be fewer B tokens in the pool, and the price of B will go up. That’s simple supply/demand economics.
Liquidity pools are smart contracts containing locked crypto tokens that have been supplied by the platform’s users. They’re self-executing and don’t need intermediaries to make them work. They are supported by other pieces of code, such as automated market makers (AMMs), which help maintain the balance in liquidity pools through mathematical formulas.
Is low liquidity a problem?
Low liquidity leads to high slippage — a large difference between the expected price of a token trade and the price at which it is actually executed. Low liquidity results in high slippage because token changes in a pool, as a result of a swap or any other activity, causes greater imbalances when there are so few tokens locked up in pools. When the pool is highly liquid, traders won’t experience much slippage.
But high slippage isn’t the worst possible scenario. If there’s not enough liquidity for a given trading pair (say ETH to COMP) on all protocols, then users will be stuck with tokens they can’t sell. This is pretty much what happens with rug pulls, but it can also happen naturally if the market doesn’t provide enough liquidity.
How much liquidity is there in DeFi?
Liquidity in DeFi is typically expressed in terms of “total value locked,” which measures how much crypto is entrusted into protocols. As of April 2022, the TVL in all of DeFi was $222 billion, according to metrics site DeFi Llama.
TVL also helps capture the fast growth of DeFi: In early 2020, Ethereum-based protocols recorded a TVL of only $1 billion.
Why is providing liquidity a must?
For investors, liquidity provision can be lucrative. Protocols incentivize liquidity providers through token rewards.
This incentive structure has given rise to a crypto investment strategy known as yield farming, where users move assets across different protocols to benefit from yields before they dry up.
Most liquidity pools also provide LP tokens, a sort of receipt, which can later be exchanged for rewards from the pool — proportionate to the liquidity provided. Investors can sometimes stake LP tokens on other protocols to generate even more yields.
Beware of risks, however. Liquidity pools are prone to impermanent loss, a term for when the ratio of tokens in a liquidity pool (for example, 50:50 split of ETH/USDT) becomes uneven due to significant price changes. That could result in losing your invested funds.
How to start adding liquidity?
Broadly, there are two ways of adding liquidity.
If you want to add funds directly to a liquidity pool, such as the ETH/USDC liquidity pool on SushiSwap, you will need to have equal amounts of ETH and USDC, which you can swap using any decentralized exchange.
You generally need an equal pair of tokens because trading, borrowing, and most other DeFi activities are almost always two-sided — you exchange ETH for USDC, you borrow DAI against ETH, and so on. As a result, most protocols require liquidity providers to pledge the equivalent value (50/50) of two crypto assets to available pools so that a balanced pair can be maintained. (Balancer has taken an innovative approach, allowing as many as eight tokens in a liquidity pool.)
But there’s also a less cumbersome way.
You can “zap” into a liquidity pool — adding liquidity in just one transaction through platforms like Zapper, which invented the concept in 2020. Just go to zapper.fi and connect your wallet. Click “pools” to list the liquidity pools available for zapping in and out. Add liquidity to the pool using whatever asset you have. Zapper will exchange them into equal splits of the relevant pair. That saves a couple of separate transactions!
However, Zapper doesn’t list all liquidity pools on DeFi, restricting your options to the biggest ones.
The future of liquidity pools
Liquidity pools operate in a competitive environment, and attracting liquidity is a tough game when investors constantly chase high yields elsewhere and take the liquidity.
Nansen, a blockchain analytics platform, found that 42% of yield farmers who provide liquidity to a pool on the launch day exit the pool within 24 hours. By the third day, 70% will be gone.
To tackle this problem, known as “mercenary capital,” OlympusDAO has experimented with “protocol-owned liquidity.” Instead of setting up a liquidity pool, the protocol lets users sell their crypto into its treasury in exchange for its discounted protocol token, OHM. Users could stake OHM for high yields.
But the model has run into a similar problem — investors who just want to cash out the token and leave for other opportunities, diminishing the confidence in the protocol’s sustainability.
Until DeFi solves the transactional nature of liquidity, there isn’t much change on the horizon for liquidity pools.