Beginner’s Guide to Liquidity Pools & Liquidity Providers

Among cryptocurrencies, bitcoin (BTC) is the most liquid asset. It can be traded on almost every crypto exchange. There are millions of buyers and sellers for it.

Before the introduction of Decentralized Finance (DeFi), Centralized Finance (CeFi) was the standard for trading crypto coins.

Central exchanges handled all crypto trade orders. It’s usually easy to find people to quickly buy or sell the assets within this marketplace. In other words, there is liquidity.

In the DeFi ecosystem, Ether may be the most liquid asset currently as DeFi was built first on the Ethereum network. As Ethereum’s native asset, Ether can be traded on any decentralized exchange (DEX).

But there are plenty of lesser-known DeFi protocols out there and being a relatively new technology, the number of buyers and sellers in the DeFi space is small. It can be difficult to find people to trade with on a regular basis.

So how do we solve this issue? How can we create liquidity here?

That’s where the ‘Liquidity Pools’ come in.

Before explaining what Liquidity pools are, let’s take a look at understanding the term ‘liquidity’. Then we’ll move on to other related terms such as liquidity providers, LP tokens, Liquidity pairs, DEX, AMMs, and more…

What is Liquidity?

Financial liquidity refers to the simplicity with which you can convert one asset into another that can be easily used for investing or spending. Cash is considered the most liquid asset as you can exchange it to get anything else you want.

Stocks and bonds can be sold quickly and you can get your hands on the cash within a few days. You can easily sell gold to get the cash. Real estate holdings on the other hand are more difficult to liquidate - to find a buyer at your asking price and get the transaction completed.

In traditional finance, centralized organizations such as banks provide liquidity. If your bank does not have enough liquidity, then they will not have enough money to offer you when you want to make a withdrawal from your account.

Liquidity is also defined as “the degree to which an asset can be quickly bought or sold in the market at a price reflecting its intrinsic value”.

What are Liquidity Pools?

When a new DeFi application is launched, the native token of that platform may have very few takers.

An ICO (Initial Coin Offering) or an IDO (Initial Dex Offering) is launched to attract investors who buy these tokens.

Read more: What is an IDO (Initial Dex Offering)?

Once the token is listed on a decentralized exchange (DEX), the trading begins. Considering that the number of traders for this newly launched token isn’t that many, you may find it difficult to sell or buy tokens as needed.

To solve this issue, some brilliant minds in the field came up with the concept of liquidity pools.

Basically, the traders in a DeFi application, pool together their tokens to create a ‘token pool’- known as liquidity pool.

Let’s take for example a DeFi protocol such as Wault Finance with its WEX tokens. When you buy WEX tokens, you can simply hold on to them till their value goes up and sell them at a profit. Or you can add them to liquidity pools on this platform to create more liquidity for the token.

This is a form of investment where you get rewarded in different ways - depending on the DeFi protocol and liquidity pool chosen.

Read more: The Beginner’s Guide to Wault Finance

Who are the Liquidity Providers?

Now you know that a liquidity pool is created when people pool together specific crypto tokens.

People who add their crypto tokens to liquidity pools are called Liquidity Providers (LP). Anyone can be a liquidity provider in the DeFi space.

What are Automated Market Makers?

Now imagine there are plenty of tokens in a certain liquidity pool - and you want to buy some of these tokens. Let’s take the example of BANANA tokens from ApeSwap. if you want to buy some BANANA, then where do you find a seller, and how is the trade executed?

This brings us to the next innovation in the DeFi space- Automated Market Makers!

An Automated Market Maker (AMM) is an application that functions as a type of decentralized exchange (DEX) for buying and selling crypto tokens.

Traditionally (in CeFi), a trading platform uses an order book (manual or electronic) for listing all the buy and sell orders they receive. Orders are fully or partially executed based on the order book entries.

Automated Market Makers use liquidity pools, (and not the traditional market of buyers and sellers) to allow automatic trading of digital assets, without anyone’s permission.

On an AMM platform, instead of trading with a seller or a buyer, you trade against the pool of tokens in the liquidity pool.

AMMs rely on lines of code known as smart contracts to execute trades. You can think of smart contracts as robots that take the place of sellers/buyers as needed.

AMM can be considered a Peer to Contract (P2C) trade as the trading occurs between users (the trader) and contracts. A mathematical formula is used for determining the price of the tokens in the pool. The more liquidity in the pool, the easier it gets to execute trading.

The Advantages of Automated Market Makers: 

  • Automated Market Makers play a vital role in the DeFi ecosystem. With AMMs, you can trade, swap, and exchange crypto tokens instantly using the liquidity pool. 
  • You don’t have to wait for a counterparty (the buyer if you are selling or the seller if you are buying).
  • Another benefit of AMMs and liquidity pools is that trading can take place 24/7 - you can trade anytime, day or night! No holidays.

Read more: What are Automated Market Makers?

Liquidity Pool Rewards

Now, why should someone bother with providing their crypto assets to liquidity pools? What’s in it for them?

Liquidity providers are offered incentives to supply their assets to these pools. Here we shall discuss the earnings from trade fees. Staking and yield farming are some of the other ways to earn even more income from the liquidity you are providing.

1. Earning a Share of Trading Fees

Liquidity providers earn rewards (or fees) for adding their tokens to the liquidity pool. This fee is paid by traders who use the liquidity pool. 

Without the LPs, trades cannot take place due to the lack of liquidity. In other words, it is the LPs who are enabling token trading on this platform.

As a return (ROI) on their investment into the pool, they earn a share of the trading fees from all the transactions executed in this pool. This earning is directly proportional to their percentage share of the liquidity pool.

Let me break this down for you - if you add 10 WEX tokens into a pool with total liquidity of 100 WEX tokens, then you own 10% of that pool. Another person adding 2 WEX tokens owns 2% of the pool. So you will get 5 times more as a share of the trading fees compared to the second person.

For example, on Wault Finance, when you add (stake) WEX tokens to this WEX liquidity pool. It is offering you a profit of 44.08% APR (annual percentage return). You are rewarded with WEX tokens - which you can cash out, or you can add them back to the pool to increase the reward output. One WEX token is currently priced around 

$0.016 although it went as high as $0.38 in May 2021.

2. Staking LP Tokens to Earn Additional Rewards

When you add your digital assets (like WEX) to a liquidity pool, you immediately get some tokens in exchange - these are known as liquidity provider (LP) tokens.

These are not rewards. Instead, the LP tokens represent your share of that particular liquidity pool. They are like receipts used as proof of ownership for your deposit.

These LP tokens can be used for various activities, such as yield farming, on the same platform.

Liquidity Token Pairs

Although many DeFi applications have a core pool for their native tokens - such as the BANANA pool on ApeSwap, most liquidity pools hold token pairs.

A liquidity pool where BANANA and BNB tokens are pooled together to provide liquidity - is designated by the token pair BANANA-BNB

Read more: The Beginner’s Guide to ApeSwap

While adding liquidity using token pairs, you need to add equal values of both tokens. Example: For a BANANA-BNB liquidity pool, you can add $100 worth of BANANA and $100 worth of BNB to invest $200. If you are adding 1 BNB (worth $468.757 at the time of writing), you need to add 206.577 BANANA (worth $2.256) to create BANANA-BNB LP tokens.

Once you have these LP tokens in hand, you can add them to the BANANA-BNB yield farm and reap more BANANAs as rewards. You can un-stake your funds any time you wish.

Using the Same LP Tokens on Multiple DeFi Applications

There may be other DeFi apps that accept the same type of LP tokens.

For example, CAKE-BNB LP tokens can be used in farms on PancakeSwap.

Read more: The Beginner’s Guide to PancakeSwap

You can create CAKE-BNB LP tokens on PancakeSwap and then stake these LP tokens on the Pancake Bunny platform.

You can also stake these CAKE-BNB LP tokens on Beefy.Finance.

Read more: The Beginner’s Guide to Beefy Finance

3. Leveraging LP Tokens for Maximum Return on Capital

In finance, leverage is a technique that uses borrowed capital (debt) to invest in a new project or purchase an asset. Using your house as collateral to take a loan and buy another property enables you to hold on to both assets.

Similarly, you can leverage your invested LP tokens to create even more crypto assets. Let’s understand this better with an example:

1. You added $1000 (your capital) worth of crypto assets to a liquidity pool such as the BANANA-BNB pool on ApeSwap.

2. You received BANANA-BNB LP tokens in return.

3. Then you staked your BANANA-BNB LP tokens in a yield farm that offered you rewards in the form of BANANA tokens.

4. You harvest your BANANA rewards.

5. You stake the harvested BANANAs in the BANANA pool on Apeswap. This pool also offers you BANANAs as yield.

Now you can periodically harvest BANANAs from both the farm and the BANANA pool and stake them all in the BANANA pool to compound your earnings. What you are doing is ‘manual’ compounding.

There are DeFi applications that allow auto compounding. This makes the job much easier. Here is a CAKE pool that automatically re-stakes your CAKE rewards.

Make sure to check out Smart Vaults and Dual Farms on CafeSwap. CafeSwap’s automation tool repeatedly reinvests the rewards from your deposited funds to get you high levels of compounded interest. These profits are harvested and reinvested, once in four hours.

From the above DUAL farms, you get MOCHA rewards that get re-staked automatically in MOCHA pools.

Thus liquidity pools and LP tokens enable you to take the same capital and using it for multiple purposes and maximize your returns.

The 5 Major Risks of Liquidity Pools

Depositing your crypto assets in liquidity pools evidently offers many advantages. But everything is not as rosy as it seems. You do need to watch out for some thorns such as rug pulls and more importantly, you need to understand the concept of impermanent loss. Evaluate such risks before making any investments.

1. Impermanent Loss

Impermanent loss from liquidity pools - as the name suggests is a loss that is not permanent - unless you withdraw your funds from the liquidity pool during such a phase.

So what exactly is impermanent loss?

Impermanent loss occurs when the ratio of the tokens added to the liquidity pool becomes uneven. Impermanent loss is calculated as the difference in the value of the tokens in the pool versus the value of just holding them in hand (in your wallets or exchange such as Binance).

This is better explained with an example.

Let’s consider 1 BNB at $300 and a $BANANA token at $3.

For 1 BNB, you have added 100 BANANA tokens to create BANANA-BNB LP tokens worth $600.

Now if the BNB price goes up to 400 and the BANANA price falls to $2, then the arbitrage traders will add more BANANA to the pool by selling some BNB till their ratio in the pool reflects the current price.

If you withdraw your funds from the pool now, (based on your share of the pool) you will get more BANANAs and less BNB. But if you wait, the BANANA prices may go up and your loss will get evened out.

For beginners, it may take a while to fully grasp the concept.

Read more: What is Impermanent Loss?

So if the risk of such losses is high, why do people add token pairs in liquidity pools? In the long run, the rewards you receive as trading fees and yield harvests help offset the impermanent loss.

You need to be patient and allow the rewards to be compounded (manually or automatically). You should wait till the prices stabilize and withdraw your funds at the right time to minimize the chances of impermanent loss.

2. Slippage

While buying tokens to create liquidity pairs, you may experience slippage during the trading. This can also occur when you are selling the tokens you have un-staked from the liquidity pools.

The difference between the price expected for trading a token and the price at which the trade finally gets executed is known as slippage.

Slippage risk is higher for orders placed when the cryptocurrency market is experiencing periods of high volatility. 

Compared to CEXs (centralized exchanges), liquidity and trading volumes tend to be much lower in DEXs (decentralized exchanges)

In a DEX, liquidity pools have more slippage risk if you are executing orders that are large when compared to the total liquidity of the pool. While highly liquid pairs are less prone to slippage, you do need large liquidity pools for executing large trades. So when large orders are placed, there will not be enough volume to maintain the bid at the chosen price, and the price slips.

Read more: What is Slippage?

3. Smart Contract Reliance: Malfunctions and Hacks

Liquidity pools have been hacked before and investor funds lost. Although security has been tightened significantly after such attacks, the threat is ever-present.

Rather than a person or a company, the funds in DEX liquidity pools are under the temporary custody of the smart contract.

While this protects your funds from traditional counterparty and custodial risk, the smart contract may still be prone to bugs and code failures that may lead to the funds being lost or stolen.

4. Protocol Governance

The whole concept of decentralized finance or DeFi is that there is no single entity that controls the app development or the funds invested. DeFi protocols usually have a native governance token and the holders of these tokens form the DAO (decentralized autonomous organization) which votes on decisions regarding the development of the project.

But every project is different and in many cases, the developers of the project remain anonymous. There have been cases where the developers have admin keys or privileged access in the smart contract. They continue to have control of the protocol and this significantly increases the risk of them manipulating or vanishing with your funds.

5. Rug Pulls and Scams

So many new projects are being launched across the DeFi space. Sadly, some of these are just scams where a new token is launched on a reputed DEX such as UniSwap or PancakeSwap. This token is paired with another token in liquidity pools and such pools often have a very attractive APR (annual percentage rate) to attract investors towards this new token.

You get LP tokens for your share of this pool. But once the pool has adequate TVL (total value locked), the developers withdraw and sell out their self-created tokens. The rug has been pulled out from under you and you are now left with worthless tokens that are no longer trade-able.

Plenty of people have fallen prey to such rug pulls. Learn to watch out for the various warning signs of such scams and rug pulls. 

Read more: 15 DeFi Rug Pull Risks and How to Avoid Them

Before You Go…

Liquidity pools are one of the foundations on which the DeFi ecosystem is built.

A liquidity pool is nothing more than a digital pile of funds pooled together by various investors. In DeFi’s permissionless environment, anyone can add liquidity to such pools and these funds are locked up and managed by smart contracts.

The driving force behind DeFi protocols, liquidity pools enable everything from decentralized trading and automated market makers, to borrow-lend Dapps, yield generation, and so much more.

The cryptocurrency market is highly volatile and quite risky. While providing liquidity does offer multiple rewards, you must always do your research and be aware of the risks, before making any investments.

Sherwood P