Liquidity pools are a collection of digital assets that allow for peer-to-peer trading. Since liquidity is a measure of how quickly something can be converted into cash, the deeper the pool, the more liquid it is.
These are the centerpiece for decentralized finance (DeFi). To contrast traditional finance, or TradFi, is a centralized system that is packed with financial intermediaries. Exchanges, whether it is for stocks, bonds, or commodities, are centralized and responsible for liquidity. These entities operate as market makers, enabling investors and traders to move in or out of positions.
Under this scenario, funds are held by different financial parties. The exchanges are typically accessed via a brokerage firm. These are the financial institutions that holds the money on behalf of individuals.
Decentralized System
Since the release of the Bitcoin White Paper, the idea of decentralization and one owning his or her funds has been a basic tenet. A Bitcoin wallet allows one to send, receive, and store the currency without depending upon a third party.
This is enhanced by the fact that miners are all over the world, running nodes. At this point, a 51% attack on that network is unlikely. This means the decentralization, at the base layer, is present.
Decentralized finance is trying to follow suit. The key is to keep adding layers to decentralized monetary systems. Here is the challenge for different financial services since many ended as centralized. Binance, FTX, Coinbase, and Huobi are all centralized exchanges (CEX). In the end, this adds counterparty risk as evidenced by the collapse of FTX.
Liquidity pools are an essential component of DeFi.
The key to DEX is that they require no third part to hold funds. Using a wallet such as Metamask allows one to have his or her funds and then swap using liquidity pools.
They are created by using smart contracts which allows people to lock their cryptocurrency into the pool. In most instances, this enables people to earn a return by joining the pool. This is often funded through the transaction fees generated by the pool.
Impermanent Loss
This is a risk with liquidity pools.
The basic idea is that as the value of the coins or tokens fluctuate, the price of the pool does the same. If both of the pair goes down, the value of them drops. The fear here is the drop takes place and never recovers.
Under this situation, the liquidity provider would experience a loss by holding the assets in the pool.
The reason it is impermanent is because the loss can be erased. If the prices recover, this could mean that whatever "loss" was experienced is negated. It only becomes permanent if the liquidity provider decides to exit the pool, thereby locking it in.
Assets also can move in opposite directions. It is possible for one leg of the pair to be moving up in price while the other is heading down. Depending upon size of the moves of each position, the value of the holdings, net, could be in a negative.
The least amount of impermanent loss takes place when there is a stablecoin as one of the legs of the pair. Since this is designed to hold its value, the volatility is then experienced only on one side. Downward moves means the volatile coin or token will move but the stablecoin should be constant.
Ethereum Leading In TVL
Ethereum is the blockchain that is leading in smart contract technology. That means it is also leading in total value locked. This is a metric that measures the amount of money, in USD, that is locked in DeFi smart contracts.
In recent years, networks such as Binance and Polygon got into the game. Basically any EVM can duplicate this since it mirrors Ethereum to a great degree.
Ethereum smart contracts are written in Solidity. These is a newer programming language and one that has caused some issues. Many hackers found vulnerabilities in smart contracts relating to liquidity pools and use that as access to drain them.
This is done usually be creating more of the wrapped token that is created by the smart contract. When this is paired with a coin such as ETH, the "printing" of the tokens can be swapped for the ETH that is in the LP. This is then moved to another wallet, leaving the LP with an abundance of the now diluted tokens.
Some developers are looking at creating platforms that allow the creation of smart contracts using languages that most are familiar with such as MySQL. This is something being discussed on the Hive blockchain.
Since TVL is prices in USD, as cryptocurrency finds itself in a bear market, the amount locked drops. This tends to cast a negative light on the protocols.
Pairs
The key to liquidity pools is they always contain two coins (or tokens). The reason, much like FOREX, is they operate in pairs.
If the LP is handling both sides of the trade, it has to have currency available regardless of what the individual wants to do. The LP is responsible for both buying and selling of an individual coin or token.
Those who are staking to the LP tend to put up both. For example, if someone is contributing $1,000 in total, $500 of each coin would be staked.