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Liquidity Pools and How They Work

By Todd Mei PhD | Crypto U Education | 20 Jan 2023


Taking “the leap of faith” with cryptocurrencies has less to do with just jumping in and buying a few coins. It has more to do with buying into the ideology it generally represents. Once you do that, then you very quickly begin to see that just jumping in and moving fast are liabilities when making crypto trades — mistakes can easily happen when transacting in the Web3 space, and emotion can often get the best of you in the wrong way (e.g. reacting to fear of missing out).

So this article on liquidity pools is meant to introduce their functional basics — both financial and algorithmic — by way of the ideology underpinning blockchain technology — namely, financial empowerment. Don’t worry, I won’t launch into a philosophy lecture on this last bit . . . as tempted as I am!

By the end of this article, I hope you will have understood the basics of liquidity pools so that, should you decide to make the jump, you’ll have a good-enough foundation to investigate opportunities further and keep your head above the ever-changing and volatile waters of the crypto market.

Financial Empowerment, Not Freedom

You’ve probably heard the phrase “financial freedom” thrown around by those who adamantly support cryptocurrencies. Because the cryptocurrency space is decentralized, it is not controlled by banking authorities or governments.

There are, of course, practical benefits and drawbacks to decentralized finance (or DeFi). On the plus side, most transactions occur quickly and can be executed 24 hours-a-day, 7-days-a-week. On the minus side, as you have probably heard, there is no regulation to protect consumers and investors. As well (as I can attest), making mistakes while moving coins around is very easy to do. And once a mistake is made, those assets really do disappear into the ether.

Ideologically, the primary benefit of DeFi is that it lacks an authority or organization who can skew the game of financial opportunity. Let me unpack this a bit with a contrasting example. You’ve probably heard the sayings, “It takes money to make money” and “It’s easy to make money when you’ve got it”.

Imagine if you had a few hundred thousand dollars at your disposal. If you simply deposited the sum in a saving acccount that earned 2.5% APY, you’d make enough in interest to support yourself. Roughly $85,000 would accrue in compounded interest over 1 year.

But how many of us can get access to that amount of money?

A centralized finance environment (or CeFi) is skewed in favor of the wealthy and rich. The rich tend to have a good credit history; and even if they don’t, they tend to wield enough power and influence to get access to large amounts of cash at relatively very little cost.

You don’t need to be a math wizard. Banks will often provide rich clients with generous loans and interest rates. Even with a 6.5% APR on a loan, a rich person could easily work out how to invest the loan amount in the short-term to yield a net profit. It’s basically free money to make money.

In short, CeFi is all about preferential treatment. Whereas DeFi is about removing the banking institution so that anyone can invest, deposit, buy or sell. Want to take out a loan? All it requires is collateral, not a banker’s approval.

Libertarian-minded enthusiasts have therefore seen DeFi and crypto as dawn of “financial freedom”. No intereference from banks and governments.

But I’m not a libertarian. (Ironically, I think libertarian thought conceives of the idea of freedom too narrowly in terms of the individual and a kind of unmitigated power and right to do what one pleases with little constraint.)

Notwithstanding this reservation, I think it’s more accurate to call what DeFi has to offer financial empowerment. This is because, in general, DeFi allows a broader range of individuals to increase their respective financial capability. Specifically, there at least two ways we can see this:

  1. It levels the playing field a bit more between the rich and poor, such that the financially not-as-well-advantaged can gain access to financial growth opportunities (assuming DeFi is user-friendly and the rich don’t find a way to control DeFi).
  2. Financial empowerment does not mean freedom from regulation. Regulation is a good thing when it is reasonable. It sets expectations and standards that come with real sanctions and consequences for bad actors.

We’re a ways off from both, and to hear more about this, you can listen to my podcast with cryptocurrency influencer, Sebastian Purcell.

For now, let’s turn to liquidity pools — how they work and how they circumnavigate the need for banks.

Decentralized Exchanges — We’re Not in Kansas Anymore

Liquidity pools are offered on decentralized exchanges (or DEXs). Not all exchanges on the blockchain are decentralized.

A centralized exchange, like Coinbase or FTX, acts just like a traditional financial intitution in so far as it relies on a centralized authority to coordinate and execute the exchange of cryptocurrencies. To function, they will use traditional market makers — that is, centralized exchanges have a community of clients who provide liquidity for trades.

A centralized exchange has the advantage of being able to match buyers and sellers with little slippage in the trade price. Slippage occurs when a coin’s price changes between the time it is executed and when the trade is finalized. So you could be buying an asset at $100, only to see it has gone up to $115 by the time the trade is finalized. Centralized exchanges mitigate slippage by having a robust list of clients and institutions who are available to make the trade “on the spot”.

A DEX, such as Uniswap or Sushiswap, uses blockchain protocols (i.e. smart contracts) to allow people to trade cryptocurrencies. There is no centralized authority organizing the trades or providing a base of market makers. Instead, DEXs facilitate trading via liquidity provided to a pool, while smart contracts automatically ensure that for each action taken, a specific outcome occurs.

So instead of providing a list of clients who can provide liquidity (or market makers), DEXs use an automated process to create a pool of assets that can be bought and sold. Hence, they use Automated Market Makers (our next topic!).

However, while the process is automated, it is not instantaneous. Slippage can be a real problem on DEXs, especially when there is not a lot of trade volume.

What Is an Automated Market Maker?

A market maker is a person who supplies an exchange with the assets that it needs to enable trading. Automated market makers (or AMMs) accomplish the same thing, but with blockchain code (i.e. smart contracts) in the place of an actual person. We can take a step back to understand what’s at work.

All exchanges are markets. Just like a farmer’s market where people exchange money for food, with a financial market, people are exchanging money for other financial items. For the market to be successful, you need people who are offering the goods that people want. For example, people might want to exchange a stablecoin, USDC, for Ethereum (ETH).

In a centralized exchange, a market maker is a person who will allow any person wanting to exchange USDC for ETH by supplying the relevant token for that to happen.

In a DEX, there is no such person as part of the exchange process. As a result, DEXs use automated market makers. This is an algorithm (executed by a smart contract) that draws from a pool of reserves to allow a purchaser to swap the coins they want.

But where does that reserve come from? DEXs allow anyone (i.e. financial empowerment) to supply liquidity to a pool. These suppliers are rewarded for doing this by receiving a cut of every transaction in that pool (in proportion to how much liquidity they provide). Yes, financial empowerment — banks aren’t making any money here off your deposit (e.g. fractional reserve lending).

Instead of banks, we have liquidity pools.

Unpacking the idea of a Liquidity Pool

A liquidity pool is a pool that contains a reserve of coins on which an automated decentralized protocol can draw. Smart contracts not only enable users to buy and sell coins from the pool, but they also help the pool to maintain a balance between market price and token supplies within the pool.

Liquidity pools are the hubs utilizing AMMs. Their purpose is to help grease the wheels of the crypto market by providing more people with cryptocurrencies (i.e. liquidity) to trade, buy, etc.

Let’s put this problem-solution into more relief:

Low liquidity is a problem for markets because it means people can get stuck with the coins and tokens they are holding. There just isn’t enough in the system for people to trade. Low liquidity also results in high slippage, or a greater difference in the execution price of a trade and its finalization price.

The initial or opening liquidity is provided by the pool owner. The owner offers two coins to be traded — such as, ETH and DAI. The minimum amount that an owner needs to provide is usually around $500,000. Subsequently, users can provide additional liquidity in any almost any amount and become liquidity providers. To reiterate, providers make a profit on transaction fees whenever borrowing is executed by other users. The more liquidity one provides (or the more one’s deposit constitutes the share of the pool), the greater the percentage one takes away from the transaction fees.

Additional rewards can involve being given liquidity pool tokens, which can be highly valuable themselves depending on the pool. So, for example, you may have provided two stablecoins to a pool on the Curve DEX. In addition to getting a percentage of the transaction fees, you might also be rewarded with Curve tokens (CRV).

An interesting strategy to note about people who use liquidity pools as a substantial form of income, per Decrypt:

“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.”

This type of strategy capitalizes on the initial trade volume with less exposure to impermanent loss; or the loss in value of the tokens supplied (as a result of the trading activity in the pool) in comparison to the value of the tokens if you just held them in a wallet.

The problem with this strategy is that it is inevitably parasitic on the pool. If the providers have a large enough stake in the pool, their exit can cause low liquidity problems as well as creating impermanent loss for those still in the pool. In the worst case, the affected pool can crash.

How This Can Be Applied

Knowing how DEXs, AMMs, and liquidity pools function and inter-relate is the first step in the process of education and due diligence of cryptocurrency investment — i.e. financial empowerment.

The crypto space is still far from mature, and it is still very easy to make operational as well as finacial mistakes. The advice of Dirty Harry Callahan might service some use in this context (I paraphrase): A person’s got to know their limitations!

This article originally appeared on Medium and is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.

Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.

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Todd Mei PhD
Todd Mei PhD

Todd is a former Associate Professor of Philosophy with over 16 years of research experience in the philosophy of work and economics. He is currently the lead researcher and writer for the Web3 consultancy group, 1.2 Labs.

Crypto U Education
Crypto U Education

Cypto U is a series of blogs providing educational content for crypto enthusiasts. Content and lessons have been taken from The Art of the Bubble and 1.2 Labs.

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