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Liquidity Pools and Their Role in the DeFi Space

December 18, 2023

Following the post about common liquidity problems, which the Kinetex team posted last week, let's talk about the most critical component of the liquidity supply and maintenance in the DeFi space — liquidity pools.

Order Books vs. AMMs

Liquidity pools are part of the decentralized liquidity model developed to overcome shortcomings of order books widely used on centralized platforms. When using order books, trading happens between users who buy or sell their crypto assets. In order to ensure there is enough liquidity at any point, centralized exchanges involve market makers who are ready to sell or buy assets to satisfy user demand. Having multiple downsides, such an approach has been criticized for its inefficiency. First of all, it is centralized. Since exchanges serve as a middleman between users, they have power over the process. In addition, they often serve as market makers, further enhancing their power over the market.  

Decentralized platforms were keen on developing a model that could save the main crypto principle during trading - decentralization. Thus, automated market makers (AMMs) were created. They are automated smart contracts that allow continuous trading without waiting for sellers and buyers. Users can trade against liquidity pools that consist of users' funds locked into smart contracts, creating a reservoir of assets available for trading or lending at any time of the day. 

Most AMMs use two-token liquidity pools to allow users to trade two tokens against each other. If the demand for either token increases, the AMM will increase its price accordingly. However, these pools are not very flexible since there are hundreds of token pairs users like to swap regularly, meaning projects often have to have and maintain many pools. This is why more projects are looking into employing multi-token pools that can hold more than one pair simultaneously. 

AMMs & Pool Balancing

Liquidity pools cannot simply exist as they must be constantly observed and kept in balance, which is the job of AMMs. The system works as follows. Each liquidity pool starts with a predefined ratio of assets and is designed to maintain a balance while users contribute funds to both sides of the pair. Therefore, users must deposit funds in a particular proportion (for example, 1 ETH: 4000 ADA). 

AMMs use a mathematical formula called the constant product formula to ensure that asset prices remain balanced. The most commonly used formula is the quantity of Asset A multiplied by the quantity of Asset B equals k, where 'k' is a constant. The constant product formula ensures that the ratio of the two assets stays the same as users trade against the liquidity pool by constantly adjusting it. This automatic price adjustment helps to maintain liquidity and reduce slippages.

However, projects can also use other formulas and change according to their objectives and market situations. This flexibility is necessary since market conditions and user behavior can vary, sometimes causing major pool disbalance. In such cases, AMMs can allow for the migration of liquidity to different pools or the optimization of existing pools to accommodate shifting market demands.

Liquidity Providers

Apart from AMMs, liquidity providers are the second component crucial for the smooth operation of liquidity pools. Even though the terms' market makers' and 'liquidity providers' are often used interchangeably, they are not entirely the same. The first are entities or individuals who facilitate continuous trading by providing buy and sell quotes for an asset, thus ensuring an orderly and liquid market. Liquidity providers refer to entities or individuals adding liquidity to the market. This term sometimes encompasses all participants contributing assets to the crypto market, including market makers, and sometimes refers only to those providing liquidity to the pools. 

As liquidity providers are instrumental in maintaining the pool operation and bear all the risks associated with changes in asset prices (for instance, impermanent loss; read more about it here), projects have to motivate them to contribute. Typically, providers are incentivized by rewards in the form of a percentage of trading fees, unique LP tokens that can be used in the platform, or even governance tokens. These incentives encourage users to stake their assets in pools despite the possible risks.

Importance of Liquidity Pools in DeFi

As mentioned above, liquidity pools were created in search of a more decentralized and efficient approach to trading crypto assets. With pools and AMMs, users can swap assets more quickly, smoothly, and at any time of the day. Besides, they allowed DeFi projects to leave the use of order books behind, which, unfortunately, made the swapping process more centralized. 

Another advantage of liquidity pools is their effectiveness in ensuring liquidity for assets with historically low trading activity. Thanks to incentive programs that DeFi projects create for liquidity providers and different ways of rebalancing and optimizing liquidity in pools, users have a better chance of finding adequate liquidity for less popular assets in DEX pools. Consequently, it broadens the crypto horizons for users, enabling them to take advantage of opportunities they may not have been able to access otherwise.

Liquidity pools also provide many profit opportunities for liquidity providers. A practice of locking up assets in liquidity pools to earn a higher return is called yield farming, and it has become increasingly popular among crypto holders. Farming enables individuals to earn passive income while supporting cryptocurrency trading, motivating many crypto holders to participate in maintaining the DeFi market instead of holding their assets in their wallets.

Finally, when lending protocols are concerned, liquidity pools are an essential element, too. They enable borrowers to access crypto assets they may need and lenders to profit from lending their assets. By pooling together funds from multiple parties, liquidity pools ensure that sufficient capital is always available for users to borrow. This way, lending projects help traders without significant capital to participate in trading, supporting the development of the DeFi industry.

Final Thoughts

While liquidity pools are unquestionably vital for the DeFi space, they also have their own risks, including frequent hacker attacks. This is why many DeFi projects, including Kinetex, seek ways to eliminate vulnerabilities associated with locking tokens on their platforms, which is possible through aggregating liquidity or enabling direct trades between users. Both approaches are available through the Kinetex dApp.  

Kinetex Network: Website | Kinetex dApp