Water is essential to life on the earth, it matters to plants and human beings. It is certainly important in regular situations but even more important when the sun is turning up the heat within our world.
This is the same case within the financial markets, liquidity is quite critical to having smooth financial transactions.
As rivers flow through and provide refreshment to land, plants, animals, and human beings, liquidity in the financial system helps to keep the financial engine going. If there is high liquidity, then individuals can buy assets and then convert them to cash in a swift manner.
Let us find out more about crypto liquidity, liquidity pools, and why it is critical.
💧 Liquidity
Liquidity is the ability of individuals to get in and out of an asset as fast as possible. For instance, it is possible to buy and sell many different stocks quickly. But why is it possible to do so? It is because there are many buyers and sellers at any given time.
A decent portion of stocks will continue to see the right level of buying and selling, making it to where individuals could enter a position and exit a position without fears of being stuck. In times of chaos, you will see that this is not the case. For instance, during extreme drawdowns, it is possible to see many different sellers that could lead to precipitous declines in assets.
As there are no buyers in certain times of extreme stress, there is not as much liquidity, because funds are not flowing into assets and instead are flowing out of them.
Alternatively, some assets are by definition, less liquid. A house is not as liquid because it takes a bit longer to sell it. Individuals may have more difficulty selling a house because houses come with different conditions, are usually at a higher price, and requires individuals to make real decisions about their commitments.
Private equity investments are also more illiquid because the market is much slimmer.
In the world of decentralized finance, liquidity is essential. But how do we make sure that there is a certain amount of liquidity present within this sector? Liquidity pools are certainly one way to make sure that the DeFi system is thriving.
🏭 See How The Traditional Financial Sector Works
The traditional stock sector has an order book model. In this model, there are buyers and sellers. The buyers will note how many stocks they seek to purchase, they will also note at what price they will seek to buy it at. The sellers will be present and note down their terms, they will sell at a certain price and will be a certain quantity.
When these parties meet at an agreed point, the trade is executed and a transaction takes place.
The buyer is able to obtain their respective shares and the seller is able to obtain the funds for the stocks that they sold.
There is a size, bid, and ask. This may be inefficient because there has to be a match before a transaction can take place, it can be seen as less liquid. Decentralized finance wants to make it all a little better.
🙋 Liquidity Pools Are Like Cashiers at a Fast Food Place
Take a second, imagine yourself going to a Mcdonald’s, the speed of the process is with the number of cashiers and then the efficiency of the food creators. It is essential that the cashiers have the right number of funds on hand while they process your payment. If there are quite a bit of cashiers, the line keeps on moving in the right fashion.
If you only have a cashier that is running the shop, at peak times, you might have significant congestion with a long line of customers, waiting to process their order. That is a situation that is very illiquid, it is a frozen line, and there is little to no movement.
This causes frustration, anger, and displeases customers.
In the financial markets, it creates fear, loathing, and distress. Think of liquidity pools as automated cashiers that can process orders according to a certain set of codes. They will never need to go to sleep and can continue to process these orders at different levels.
Liquidity pools are funds in a smart contract, to conduct mathematics with those respective funds, then facilitating requests with that underlying equation or programming.
Regardless of your experience level, you have heard of crypto liquidity pools. In this blog, we are going to look at various liquidity pools and how they work.
🌐 What Is a Liquidity Pool in the Cryptocurrency World?
A liquidity pool is critical because it makes it possible to move assets in and out without having to rely on buyers and sellers. This is fantastic, isn’t it? It makes it to where there is a certain level of liquidity that is always present as long as these liquidity pools exist.
Liquidity pools are smart contracts with a certain number of assets in it. Liquidity in the world of cryptocurrency means the ease to swap tokens with other tokens. A liquidity pool is when the tokens are locked in a smart contract to provide liquidity.
The smart contract is a self-executing program that runs based on the agreement made by the buyer and the seller.
The liquidity pool is funded by a liquidity provider. A liquidity provider is a user who supports the pool with their crypto asset to maintain the trading while earning passive income.
⚙️ How Does a Crypto Liquidity Pool Work?
To clearly understand how the liquidity pool works, let’s dive a little further.
Trading in the stock market occurs when a buyer and a seller meet at the same price. A seller must set a price to sell an asset they have and a buyer sets a price to buy an asset.
If you are a buyer or a seller you have to wait until those prices meet which may take a long time.
A liquidity pool self-executes the trading without you waiting for a trade to take place. The liquidity pool contains the two crypto tokens you want to trade.
For instance, in one liquidity pool, you could have two crypto coins put in the pool both with a 50:50 value ratio. The algorithm maintains the 50:50 ratio at all times. There needs to be a steady supply of the two tokens you plan to use.
The supply of tokens is managed by the liquidity providers. The liquidity providers want to participate in this liquidity pool because they earn some rewards for doing so.
If you can imagine a pool, first it is empty, then someone comes and puts some water there, the liquidity providers do so because they have an incentive. The pool becomes full of (assets). Several liquidity providers come by and add to the pool, now there are, let’s say $30,000 bitcoin and $30,000 ethereum.
The liquidity provider will get a portion of the fees relative to their level of investment.
Let us talk about how the pool works:
The pool begins with two tokens that have an equal ratio. The liquidity provider deposits the equal value of each token.
Let’s see an example:
You want to purchase Bitcoin tokens from the liquidity pool using Ethereum. You will deposit your Ethereum coin and receive Bitcoin.
Since the algorithm maintains a 50:50 ratio of the tokens, the price of Bitcoin will go higher when it is purchased and removed from the pool. At the same time, the price of Ethereum will decrease because it is being supplied to the pool.
The 50:50 ratio is maintained at all times by balancing the price of the two tokens depending on which is supplied and purchased.
Now, remember that if you seek to exchange your bitcoin for solana, there is no option here. That is where more liquidity pools come into the picture. If the second liquidity pool has ethereum and solana, then the current pool can conduct a series of transactions that involves the common denominator, ethereum, to get you what you want.
Remember, there is a small cost to conducting these transactions.
⭐ Popular DeFi Liquidity Pools
There are Defi liquidity pools that are preferred by users over any other liquidity pools. We are going to look at the top popular Defi liquidity pools that are known for their incredible impact and financial services.
- Uniswap
- Aave
- Pancake Swap
- Sushi
- KeeperDAO
- 1inch
- Terra Luna
- DeversiFi
- Kyber Network
- StarkDEX andUnipig
We will look at the 5 popular liquidity pools including Uniswap, Pancakeswap, and SUSHI.
Uniswap Liquidity Pool
Uniswap liquidity pool is a pool that runs on smart contracts on the Ethereum blockchain. You can trade one ERC-20 for another token. It is one of the successful Defi protocols for swapping tokens on Ethereum.
A user chooses the input token and the output token. They will need to specify the amount of input token and the algorithm calculates how much output token they will receive.
Uniswap has different features that set it apart from the other liquidity pools.
- Uniswap has a fixed low commission which is 0.3% per transaction
- Uniswap has automated liquidity tools that are fully executed by algorithms
- You will have full control over your funds
- You will not be required to fill out personal information (You can start exchanging quicker)
Sushiswap Liquidity Pool
It launched in September 2020 being the most popular Decentralized Application on the Ethereum blockchain.
SUSHI is an ERC-20 token of Sushiswap. It is distributed to liquidity providers on Sushiswap via liquidity mining. Suchiswap uses the automated market-making (AMM) model for its decentralized exchange.
Sushiswap doesn’t have an order book or centralized authority. In 2021, Sushiswap introduced an NFT platform called Shoyu.
Curve Liquidity Pool
Like the other platforms Curve finance also uses a decentralized exchange to trade cryptocurrency that focuses on efficient stablecoin trading. It also uses an Automated market maker model and maintains low fees.
The unique feature of Curve finance is that it focuses on stable assets. Curve finance has a token called CRV. Liquidity providers are awarded CRVs for providing liquidity on the platform.
Curve finance is also known for being low risk. The platform is also known for being convenient to remove your liquidity at any time. CRV, which is the token, gives the users the chance to boost their rewards.
The trading pairs in curve finance are designed similarly to minimize slippage.
Pancakeswap Liquidity Pool
Pancakeswap is also a popular protocol to swap tokens on the Binance chain. This means that Pancakeswap focuses mainly on BEP20 tokens which is a token developed by Binance.
It launched in September 2020 by utilizing a decentralized exchange model. The Pancakeswap also doesn’t follow an order book system and utilizes an automated market maker model.
You need to own some crypto tokens which you can buy by using fiat currencies. Then, you can withdraw the tokens to your crypto wallet. Pancake swap also allows you to remove your liquidity pool tokens at any time.
There is a token called CAKE which is a native cryptocurrency of the Pancakeswap platform. The platform has a feature called a farm. Farms are pools that are used to stake liquidity pools.
Pancakeswap gives you another service called a “lottery.” It is more of a gambling game in which you need to guess a combination of four-digit numbers within the range of 1-14.
Balancer Liquidity Pool
Balancer is among the most known decentralized exchange and automated market makers on the Ethereum network. From what we have mentioned above, Balancer is the third platform that works on the Ethereum network. This makes Balancer compete against Uniswap and Sushiswap.
Balancer is known for giving its users the flexibility to create their private liquidity pools. Balancer’s liquidity pools are open to anyone.
It is also fully decentralized and a permissionless platform. And the automated market makers are customizable to users. Balancer doesn’t have a mobile application yet. Moreover, the platform appears a lot more complicated for beginners. And it is only limited to ERC-20 tokens.
The Balancer protocol offers two major pool types for its users. These are public pools and private pools.
The public pools allow anyone to add digital assets to provide liquidity. The private pools are centralized around the creator. This means only the creator can add or withdraw the assets.
There are other pool choices to choose from in the Balancer protocol. Some of them are stable pools, weighted pools, and managed pools.
🆚 Liquidity Pool vs Staking: Which One Should You Choose?
Staking and liquidity pools are commonly discussed among crypto investors. And it is also a common question on which is better for your crypto investment. Let’s look at each of them and see their similarities and differences.
Staking
Crypto staking is when you put your digital assets on lock for a certain time in the associated blockchain network. Staking is a process that is designed for miners to help them earn more rewards. This process gives them the chance to take part in blockchain network activities.
While staking your cryptocurrency assets will be on hold as an investment on the blockchain network. This means that you can not use the cryptocurrencies you put at stake unless you want to cancel your participation in the blockchain.
You can earn various rewards as long as you are participating in the network. You can get rewards through transaction fees and others. You can minimize your transaction fees if you have assets stacked in the blockchain network.
You will also get an annual interest rate as provided by each blockchain network. The expansion of cryptocurrency and blockchain networks will develop as a result of staking. The more assets you stack, the better chance you have to create blocks.
Liquidity Pool
The liquidity pool also involves depositing tokens but you will deposit to a decentralized blockchain network for others to use for different purposes.
You will receive rewards when other users utilize the digital assets you have deposited into the pool.
What sets apart a liquidity pool from staking is the smart contract you sign with other users to know the rewards you will get from the use of your deposited assets. You will get rewards from the network for putting your tokens in the liquidity pool.
The liquidity pool gives you the chance to receive other tokens as awards. You can earn rewards from the transaction fees. You also have chances to win different rewards from the smart contracts you have with other users.
If you don’t know what to choose, you should take a step back and understand what your needs are. Understanding your needs will help you make the right decision for the long term.
In general, these are the list of the most known liquidity pools and how each of them works. Although the liquidity pools have some unique features more or less they follow the same algorithm.
It is a fantastic innovation and it can continue to improve and get better over time.