Every day, the number of people who need access to financial activities increases. To use them, they have to open an account at a financial institution or at mobile money providers, but many people can't use financial services, because they don’t meet the requirements imposed by banks.

Imagine a world where everyone can take advantage of money-related activities without the need to be banked. This is exactly what decentralized finance (DeFi) can provide, due to the amazing power of liquidity pools.

Liquidity pools are the main foundation of DeFi, allowing financial services like lending, borrowing or earning interest on individuals' crypto assets to be possible for everyone, banked or unbanked. So, no limitations imposed by financial institutions.

How?

Don’t worry, you’ll find here all you need to know about liquidity pools in crypto and DeFi.

WHAT ARE LIQUIDITY POOLS IN CRYPTO?

A crypto liquidity pool is a huge bucket full of coins that enables a trader to swap one coin in and take another coin out, paying a fee for each trade.

Traditionally, for money-related services like borrowing fiat money or opening a savings account to receive a small interest, you go to a bank. You’ll then face a high fee for the bank services and also you wait a long time until your requirements are met.

In DeFi, you can do the same activities while avoiding these disadvantages by using liquidity pools to manage your assets. Instead of fiat money, crypto coins are used, providing time efficiency, increased security and lower costs.

HOW DO LIQUIDITY POOLS WORK?

Liquidity pools are code, that work due to the power of self-verifying, self-executing and temper-resistant smart contracts, these cryptographic boxes, containing value and only unlocking if certain conditions are met.

Liquidity pools are the core of decentralized exchanges (DEXs) like Uniswap, Curve or a lending and borrowing market like Compound, keeping them liquid to execute trades.

DEXs are platforms that facilitates token swaps in a non-custodial fashion. Two mechanisms for DEX liquidity exist:

1. Order-book matching is a system, where market makers can post bids and asks to a DEX, allowing takers to fill the quotes at the previously agreed on price. Every user can see the offers. Until the offer is taken, the market maker can remove it or update the exchange rate as market conditions change. This approach is expensive and inefficient because each update requires an on-chain transaction and it's hard to find two parties willing to execute the trade under the same conditions.

1. An Automated Market Makers is a better alternative, representing a smart contract that holds assets on both sides of a trading pair and continuously quotes a price for buying and for selling. The contract updates the asset size based on buys and sells, behind the bid and the ask. It uses this ratio to define its pricing function; the price should remain risk-neutral. A fixed price ratio is usually set between two assets; when price shifts occurred, the more valuable asset would be drained.

To make things easier, here’s an example. Let’s say, on Uniswap DEX you choose the ETH/DAI liquidity pool. When you want to do a swap, the pool automatically gives the ratio of 1 ETH: 1500 DAI, based on supply and demand criteria. So, if you want to buy 2 ETH from the pool, you must deposit 3000 DAI. The mechanism of Uniswap AMM balances the prices of assets in such a way that their value is always 1:1, considering the supply and demand plus the fees. If the total value of the ETH in the pool is 4500$, there is an equivalent amount of 4500$ worth of DAI. The more DAI you buy, the more you’ll pay each time. DAI supply becomes lower and the price of ETH drops.

For swapping 2 different tokens like BAT and GRT, most liquidity pools will do the hard work for you, making automatically 2 swaps ‘behind the scene’.

The major benefits of an AMM are that it’s always available and that a traditional counterparty isn't needed to execute the trade. Coins stay in pools, waiting to be used!

FUNCTIONALITIES OF LIQUIDITY POOLS AND HOW YOU CAN BENEFIT FROM THEM

The amazing part of liquidity pools is that anyone can use them!

Swapping allows users to exchange assets between blockchains, increasing the interoperability so letting users to interact with many DeFi activities.

Liquidity pools aim to solve the problem of illiquid markets by incentivizing users.

Opposite to centralized exchanges, DEXs don’t take the fees for themself, giving specific percentages to the liquidity providers.

A liquidity provider or a LP is a user who lends his coins to the platform, increasing the liquidity in the pool, which is always a good sign. LPs get rewards from fee revenue and, in some cases, even in form of platform’s governance coins which can be used in DeFi. This is an effective way to earn passive income.

Borrowing assets from a liquidity pool is also possible, but borrowers had to deposit a collateral first (more coins than they are allowed to loan, ensuring the liquidity) and pay interest.

Why would you do that?

Due to the endless opportunities and strategies in DeFi like using borrowed coins on multiple DEXs or staking them, you can make high profits, even after paying back the loans.

Risks are everywhere and liquidity pools are no exception, the major one being impermanent loss. It occurs when is better for a LP to hold the assets instead of depositing them into a pool; it may happen because one asset went up or down in price and the other one maintained its price or went in the opposite direction. If the difference between the trading fees and the impermanent loss is significant, then a LP still made a good profit.

Connectivity, security and efficiency is exactly what anyone interested in interacting with decentralized financial services will get from liquidity pools.

Disclaimer: Not financial advice. Only educational purpose!

Follow for mor:  Elena⚡️ (@CatalinaDidita) / Twitter