Liquidity Pooling. Part 1

☘️Liquidity Pooling: The Core Of Decentralized Finance

Decentralized finance is continuing to disrupt both centralized cryptocurrency exchanges and legacy markets, with the defi sector accounting for a market capitalization of over $60 billion and daily volumes now exceeding $15 billion.

Popular defi platforms like Uniswap and SushiSwap have been a strong driver behind this growth, developing increasingly competitive decentralized exchanges (DEXes) as an alternative to the traditional order book model; made possible through liquidity pooling. Terminology in the defi space can seem baffling at the best of times but this is more straightforward in reality. So what exactly is liquidity pooling, and why is it useful?

🐳What Is Liquidity Pooling?

Liquidity pooling is central to the defi ecosystem, emerging from the automated market maker (AMM) models used to solve the liquidity challenge on DEXes, and opening up several other defi use cases.

AMMs allow tokens to be traded in an innovative, permissionless, and automated way using liquidity pools rather than the traditional buyer and seller order books of centralized exchanges and established financial markets.

Liquidity pools lock combined user funds into a smart contract to ensure token pair liquidity on a DEX. Those users are known as liquidity providers, adding an equal value of two tokens in a pool to create a market. Anyone and any project can be a liquidity provider, opening up market-making accessibility and offering a proportional share of returns from the trading fees earned in various pools, part of a process known as yield farming. Liquidity mining further adds to yield opportunities across different platforms by giving out protocol governance tokens to incentivize increased liquidity.

🚜How Do Liquidity Pools Work?

The traditional order book model of centralized venues that rely on buyers and sellers agreeing upon asset prices via a matching engine has proved ineffective for DEXes. As most DEX platforms are Ethereum-based with trades executed on-chain, high gas fees and slow throughput are less attractive for market makers, causing liquidity issues for decentralized exchanges trying to use a similar model.

Solving this, liquidity pool models have become the most popular choice for decentralized finance platforms in the Ethereum ecosystem, enabling on-chain trading without the need for an order book, compatible with most Ethereum wallets. The pools allow traders to get in and out of token pair positions that would otherwise be highly illiquid.

Rather than placing a trade with a counterparty, traders execute against the liquidity in a liquidity pool managed by a smart contract, meaning that there is no need for a buyer or seller at a particular moment, just enough liquidity in that pool.

In its basic form, a liquidity pool holds two tokens in a smart contract to create a trading pair, for example, DAI and ETH. Liquidity providers contribute an equal value of each token to the pool, effectively hedging their liquidity.

Once deposited, liquidity providers receive a pool token representing the two locked tokens and benefit from a share of rewards in pool fees and often governance tokens. Whenever users wish to withdraw from the pool, they simply burn the pool tokens to receive the locked funds back.

A formulaic approach, commonly a constant, is used to determine the price of an asset according to the ratio between the two tokens in a pool. This is managed by arbitrageurs, meaning that the prices only move when trades occur and are less manipulatable. By adjusting the formula, liquidity pools can optimize for various purposes, becoming a vital instrument in the defi ecosystem.

📚 In the next post, you will learn:

-What Are The Risks of Liquidity Pools?🛡
-Why Do People Use Liquidity Pools?💰
-Capturing the Potential Of Decentralized Finance🛸

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