DeFi actions, such as lending, borrowing, or token exchange, are based on smart contracts — fragments of self–executing codes. Users of DeFi protocols “lock” crypto assets in these contracts, called liquidity pools, so that others can use them.
Liquidity pools are an innovation of the crypto industry that has no direct equivalent in traditional finance. In addition to providing a lifeline to the core business of the DeFi protocol, liquidity pools also serve as hotbeds for investors with an appetite for high risk and high returns.
How do liquidity pools work?
In order for any economic activity to take place in DeFi, there must be a cryptocurrency. And this cryptocurrency needs to be supplied somehow. This is exactly what liquidity pools are designed for.
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 rise. It’s a simple supply and demand economy.
Liquidity pools are smart contracts containing locked crypto tokens that have been provided by platform users. They are self-fulfilling and do not need intermediaries to make them work. They are supported by other parts of the code, such as automated market makers (AMM), which help maintain balance in liquidity pools using mathematical formulas.
Why is low liquidity a problem?
Low liquidity leads to high slippage — a large difference between the expected price of a token transaction and the price at which it is actually executed. Low liquidity leads to high slippage, because changes in tokens in the pool as a result of an exchange or any other activity cause a greater imbalance when there are few tokens locked in the pools. When the pool is highly liquid, traders will not experience much slippage.
But high slippage is not the worst possible scenario. If there is not enough liquidity for this trading pair for all protocols, then users will be left with tokens that they will not be able to sell. This is what happens with a “Rug Pull”, but it can also happen naturally if the market does not provide sufficient liquidity.
How much liquidity is there in DeFi?
Liquidity in DeFi is usually expressed in terms of “Total Value Locked” (TVL), which measures how much cryptocurrency is entrusted to the protocols. According to the metrics website Devis Lama, as of April 2022, TVL in the entire DeFi was $222 billion.
TVL also helps to record the rapid growth of DeFi: at the beginning of 2020, Ethereum-based protocols had a TVL of only $1 billion.
The Future of Liquidity pools
Liquidity pools operate in a competitive environment, and attracting liquidity is a difficult game when investors are constantly chasing high returns elsewhere and taking liquidity.
Nansen, a blockchain analytics platform, found that 42% of farmers providing liquidity to the pool on launch day exit the pool within 24 hours. By the third day, 70% will disappear.
As long as DeFi does not solve the transactional nature of liquidity, no special changes are expected for liquidity pools.