The introduction and adoption of cryptocurrency have reshaped the world economy dramatically. It has had revolutionary changes in various industries and given birth to a whole new banking system called Decentralized Finance (DeFi).
Many individuals have already adapted themselves to decentralized platforms, enhancing their capabilities and earning potential, but many are still on the fence due to the lack of proper information and knowledge.
In this article, we will be addressing the confusing concepts of liquidity and liquidity pools in cryptocurrency in an easily digestible manner. This is aimed to empower you to make informed decisions and be aware of the inner workings of the DeFi space. So, without further delay, let’s get into it.
Is Liquidity and Liquidity Pools the Same?
Table Of Contents
- 1 Is Liquidity and Liquidity Pools the Same?
- 2 What is Liquidity?
- 3 What Dictates a Cryptocurrency’s Liquidity?
- 4 How Crypto Exchanges Provide Liquidity?
- 5 What are Liquidity Pools?
- 6 The Pricing Mechanism of Liquidity Pool
- 7 How To Invest in a Liquidity Pool?
- 8 The Working of Liquidity Pool
- 9 What is Yield Farming in Liquidity Pools?
- 10 Pros and Cons of Yield Farming
- 11 Conclusion
Even though both of the terms – liquidity and liquidity pools are associated with cryptocurrencies they are not the same.
Liquidity is the measure of how quickly a cryptocurrency can be purchased or sold on the market without significantly losing its value. On the other hand, a liquidity pool is an algorithm-based digital reservoir that can hold multiple cryptocurrencies together and facilitate their trading without the presence of a centralized entity. Let’s explore each in detail.
What is Liquidity?
The ease of buying, selling, and trading cryptocurrencies without affecting their price is called liquidity. Cryptocurrencies that have high liquidity are easy to trade, whereas it is difficult with low liquidity assets. This is because you can easily find a seller or a buyer for high-liquidity cryptocurrencies.
Liquidity can vary according to the particular cryptocurrency you hold, and the trading platform you are using. Usually, the most popular cryptocurrencies such as Bitcoin, and Ethereum have strong community backing and are supported by most exchanges, making them easy to trade without significant price slippage, but that is not the case for all crypto assets.
Essentially, the cryptocurrencies with high trading volume and better market capitalization would have more sellers and buyers, hence higher liquidity.
What Dictates a Cryptocurrency’s Liquidity?
Liquidity is important when considering a safe investment option. However, as with the price of cryptocurrencies, its liquidity can also vary depending on certain factors such as:
- Market Sentiments: The confidence of the market participants towards a cryptocurrency can change according to the press headlines, government regulations, and social media influence. The positive perception can increase market activity and liquidity, and vice-versa.
- Trading Volume: Trading volume is the total number of trades happening in a 24-hour window. So, the cryptocurrencies with higher trading volume will in turn have a higher liquidity compared to the assets with lower trading volume.
- Scalability: The scalability and technological advancements happening in a blockchain can improve its security, transaction speed, and transaction fee. This can improve its popularity and attract more investors which can translate to its liquidity as well.
How Crypto Exchanges Provide Liquidity?
The liquidity of a cryptocurrency means the easiness of a user to buy or sell them for other assets. Users can rely on exchanges for proving this service. Many exchanges work in a decentralized model using algorithms and smart contracts.
Here, the users can do transactions without needing to go through a third-party entity. This is facilitated by using liquidity pools that utilize the smart contract known as Automated Market Makers (AMM).
What are Liquidity Pools?
Liquidity pools can be considered as reservoirs that hold multiple assets together. User can use it for trading their assets for another asset held in the liquidity pool. Liquidity pools are the heart of decentralized exchanges (DEXs). Since it uses Automated Market Sn They are not bound by conventional buyer-seller dynamics. The trading is entirely carried out through the algorithm called Automated Market Makers.
This allows permissionless transactions of cryptocurrencies without the interference of a trusted third party. This enables decentralized transactions guarded and maintained by algoirithms. It controls everything including the pricing mechanism.
The Pricing Mechanism of Liquidity Pool
A liquidity pool uses a dynamic pricing mechanism that aligns with the supply and demand in the market. This is achieved by locking two or more cryptocurrencies in the pool in the ratio that reflects their market value.
For example, if a liquidity pool has 50 cryptocurrencies A and 100 cryptocurrencies B, it means that one cryptocurrency A is worth 2 cryptocurrencies B. When a trade happens, this changes the ratio and the price of each cryptocurrency by the extent.
Here, the total liquidity stays constant, making it hard for attackers to manipulate the price. Here is how the constant liquidity is calculated.
number of A x number of B = K, the constant.
You can do an infinite number of transactions on the liquidity pool and the K remains constant all the time.
How To Invest in a Liquidity Pool?
There are many decentralized finance (DeFi) platforms in the cryptocurrency market. The exact procedure for joining a liquidity pool can vary according to the DeFi platform. However, it typically involves the following steps:
- Step 1: Open an account on the DeFi platform and log in to your account.
- Step 2: Connect the supported wallet to your account. Some of the supported wallets include Metamask, fortmatic, or other Web 3 wallets.
- Step 3: Find the liquidity pools offered by the platform. You can typically find them on the “Liquidity Pools” tab from the menu.
- Step 4: Click on Create Your Pool, and go through the procedures to deposit your two different tokens into the pool. ‘
- Step 5: Once the pool is created, you will be able to monitor it from your dashboard. You may check the profit/loss, daily return, average cost, and fees paid, to ensure your liquidity pool is performing well.
Usually, the DeFi platforms make it easy for users to participate in the liquidity pool and withdraw their coins. However, you need to ensure that the platform you chose is credible and trustworthy. You may also need to research the historic reputation of the platform, before locking your cryptocurrency in a liquidity pool.
The Working of Liquidity Pool
To further understand liquidity pools which are one of the most integral parts of DeFI, let’s break down the different factors involved in its working:
Liquidity Providers (LP)
Users who provide their cryptocurrencies as liquidity in the pool are called liquidity providers. They receive LP tokens from the respective platform as a guarantee for their liquidity. LP tokens on their own can have value and will be useful in the DeFi platform. LPs also receive a portion of the transaction fee from the platform as an incentive for their contribution.
AMM
AMM or automated market makers are the revolutionary algorithms that are responsible for maintaining the trustless DeFi space by governing the price of the tokens. They use mathematical equations to determine the token prices held in the liquidity pool, where the products of two cryptocurrencies in the pool remain constant. This limits the need for an order book that centralized, traditional markets use.
Peer-to-Contract Model
Usually, centralized transactions happen on a peer-to-peer model. However, a liquidity pool works as a peer-to-contract model, where the user interacts with the smart contract rather than another user. This removes the need for a trusted authority to stay in between the transactions.
Security
The liquidity pools are constantly tested to find out their vulnerabilities and fix if any security concerns are found. This rigorous audit is one of the major factors making liquidity pools secure, and robust against manipulations and cyber attacks.
Governance
The participants of certain liquidity pools can involve themselves in its governance, and updations. The voting privileges may extend to deciding on the fee structure, upgrading algorithms, and improving the services. To vote on the changes, the users need to hold the governance token of the platform.
Integration of Other Protocols
The AMMs can be modified to include other DeFi protocols to improve the services they offer such as lending protocols, yield farming, and more. Lending protocols make it possible for the user to borrow cryptocurrency funds.
Whereas yield farming allows liquidity providers to earn high returns. This inclusion of additional protocols is essential for providing complex financial services that the users are looking for.
What is Yield Farming in Liquidity Pools?
Yield farming is an investment strategy to get high returns by lending, borrowing, or staking crypto assets on a decentralized finance platform. Here the LP (liquidity provider) gets more liquidity tokens for their contribution.
It works by allowing the users to stake their cryptocurrencies on various trading pairs. The process of staking cryptocurrencies for receiving maximum yield or returns is called yield farming, and the user that provides liquidity for yield farming is the “yield farmer”.
Yield farmers can use DEXs for lending, borrowing, and staking their coins for maximum returns. However, yield farming is a high-risk and highly volatile investment option. So, users should only go with yield farming after doing the due diligence of researching about various pros and cons that yield farming comes with.
Pros and Cons of Yield Farming
As we mentioned before, Yield Farming can be a highly beneficial investment option with a high-risk quotient. So, it is best to compare its pros and cons before reaching a decision.
Pros
1. High Returns
Yield farming is one of the best ways to optimize the returns from staking cryptocurrencies. In yield farming the users can earn rewards from multiple platforms and protocols at the same time.
2. Adaptability
Yield farming allows liquidity providers to better adapt to market conditions by diversifying their exposure to various crypto assets, protocols, and platforms. They can switch platforms if a better opportunity opens up. This allows them to maximize risks while helping them make contingency plans.
3. Discover more opportunities
Yield farming is one of the detrimental factors that is moving the decentralized platforms forward. This constant progress in the trustless space can lead to more innovations and updations making way for the introduction of more useful protocols and more ways to earn. Essentially, by providing liquidity, you are helping the cryptocurrency market progress as a whole.
Cons
1. Smart contract vulnerabilities
Smart contracts are the gatekeepers, governors, and facilitators of yield farming. They are computer programs that will only execute, once the user satisfies the pre-set condition. As with any computer program, smart contracts are not immune from bugs and vulnerabilities.
Historically many attackers have exposed the vulnerabilities related to poorly audited smart contracts, which have led to the online theft of the user’s funds.
2. Impermanent Loss
The price of the cryptocurrencies that are held in a liquidity pool can dip at times due to the volatility of the trading pairs. When the users swap their coins using a liquidity pool, the AMM adjusts the price of the tokens involved, which may reduce the value of LP’s token. While some DeFi platforms compensate LPs by providing additional tokens or extended earnings, it might not be a guarantee.
3. Gas Fees
Ethereum network is the most popular blockchain platform used for DeFi and Yield Farming. The network requires users to pay transaction fees called gas fees to facilitate the transaction. It can vary depending on the network congestion and traffic. Gas fees are higher when the network is more congested. This can limit the returns from yield farming and can even make it unprofitable.
4. Governance Risks
As we have mentioned in earlier parts of this article since Liquidity Pools are carried out on decentralized platforms, the governance happens through voting instead of an LP-focused governance structure. This may lead to poor decisions that may jeopardize user funds.
Conclusion
Liquidity is the easiness of exchanging cryptocurrency for another asset without affecting its value significantly. Liquidity varies according to various factors including market perception, trading volume, scalability, and technical advancements among others.
Liquidity for a cryptocurrency is provided through decentralized finance (DeFi) platforms such as decentralized exchanges (DEXs) using liquidity pools.
Liquidity pools hold multiple coins in a digital vault using smart contracts and make it possible for users to exchange one cryptocurrency for the other. Liquidity pools function without the help of a third-party intervention.
In this article, we have delved into the inner workings of liquidity pools and explored how you can participate in them.
