A crypto liquidity pool allows you to lock your tokens in a pool of cryptocurrencies where they are put to use, and you, in turn, earn passive income. It also has many benefits for crypto and decentralized finance (DeFi) networks as they shift away from how centralized crypto exchanges operate.

In this article, we will look at what a crypto liquidity pool is and its role in DeFi networks.

What Is a Crypto Liquidity Pool?

A liquidity pool is a pool of crypto tokens secured under a smart contract. These tokens provide decentralized exchanges with the essential liquidity they require. The term "liquidity" refers to the ease with which one can swap a crypto token for another. Such ease is essential to the DeFi ecosystem because of the numerous financial activities carried out in it.

Although the decentralized trading sector contains a great number of liquidity pools, only a select few of them have established themselves as the investors' first choice. They include Uniswap, Balancer, Bancor, Curve Finance, PancakeSwap, and SushiSwap.

How a Liquidity Pool Works Versus an Order Book

A liquidity pool is like a pot containing crypto coins locked up in a smart contract that allows people to trade easily. The importance of liquidity pools is better understood when we compare them with traditional order books.

The order book is a digital list of crypto buy and sell orders arranged by price levels and updated continuously in real-time. In simple terms, buyers and sellers submit orders for the number of tokens they want to trade and at what price. The method requires that someone else be willing to meet the order. Otherwise, traders would transact at an unfavorable price or wait for a long time to see someone who meets their desired price.

Liquidity pools ensure that buy and sell orders are carried out no matter the time of the day and at whatever price you want to trade without looking for any direct counterparty. The system uses an Automated Market Maker (AMM) to ensure this. You won't need to find a seller to buy a token. All that is needed is sufficient liquidity in the pool.

When a token swap occurs, the AMM ensures that the price adjusts based on its algorithm. The algorithm ensures that there is always liquidity in the pool, no matter the trade size.

A liquidity pool is, by default, a 50:50 ratio of 2 coins. Let's say 50% bitcoin (BTC) and 50% ether (ETH). When you buy BTC with ETH, the pools will start to lose BTC and get more ETH. The algorithm increases the price of bitcoin and lowers the price of ether to keep the ratio regulated. The process is a self-regulated automated reaction to the market's needs.

Advantages and Disadvantages of Order Books

The order book system also has its advantages. The system, which has been used for many years, allows buyers and sellers to make more informed decisions. The order book reveals imbalances in the market, which traders can use to get insight into short-term market trends. For example, when there is an increase in the number of buy orders, there will likely be an increase in price because an increased number of traders are bullish.

a btcusd order book

The order books can also be used to identify the areas of the market that are creating support and resistance. For example, strong support may be found in an area with several buy orders, while you may find resistance support in an area with multiple sell orders.

The order book also presents some challenges, one of the most significant of which is a lack of transparency. Exchanges have been caught engaging in price manipulation, insider trading, wash trading, as well as manipulating their trade orders. As a result, the order book gives traders false information, which leads them to make trades they shouldn't.

As more centralized exchanges store the information and documents of their customers, there is a greater possibility that the information of customers could be exposed in the event of a data breach.

Order books are used by a lot of centralized exchanges, including Binance and Coinbase. The order book is also used for trading stocks on traditional stock markets. However, order books don't work well when the market isn't very liquid. This is because finding a match won't be easy, and you might have to wait a long time to execute your trades.

3 Advantages of Liquidity Pools Over Order Books

Below are three benefits that liquidity pools have over traditional market-making systems.

1. There Is Liquidity at All Price Levels

You don't have to connect to other traders to trade because there is always liquidity as long as client assets remain in the pool.

You won't need to worry about finding a partner that would like to trade at the same price as you. Instead, the algorithm adjusts the value of crypto based on the platform's exchange rate.

uniswap homepage screenshot

2. Better Price Balance

With liquidity pools, no seller can demand high market prices. Likewise, buyers cannot devalue the market price below the average price. As a result, the transactions are smoother, and the market is more balanced.

As soon as a liquidity provider deposits money into the pool, smart contracts take complete control of setting the price.

3. Anyone Can Provide and Benefit From It

The provision of liquidity is not limited to market makers, and anyone can provide liquidity. Listing fees, KYC requirements, and other barriers associated with centralized exchanges are not required for liquidity pools. To provide liquidity to the pool, you will only need to make a deposit that is equal in value to the assets.

Liquidity providers are usually rewarded with fees, which can be a form of passive income.

3 Risks of Liquidity Pools

There are also some drawbacks to liquidity pools. Three of these issues are explained below.

1. Impermanent Loss

The value of a crypto token may change in comparison to another due to demand and supply activities, leading to an impermanent loss of value. This issue occurs when the ratio of two assets that are held ends up being unequal due to a sudden price increase in one of the assets.

An impermanent loss makes liquidity providers lose out on the profit from one of the assets they hold. It can become permanent if a liquidity provider takes his funds out of the pool before the price recovers.

bancor network homepage

2. Smart Contract Vulnerabilities

Smart contracts manage the assets added to a pool; there is no central authority or custodian for these assets. Therefore, you could permanently lose the coins if a vulnerability is discovered.

Performing smart contract audits is a good way to ensure that smart contracts are safe from security breaches. However, the process necessitates a close look at the source code to look for potential flaws.

3. Developers Hijacking Pools

There is an opportunity for fraud in a highly centralized liquidity pool. For example, one of the developers in the pool can hijack the pool's resources. As a result, you must select your liquidity pool carefully and conduct adequate due diligence before depositing your crypto.

Be careful of projects where the developers can change the rules of the pool. For example, developers may sometimes have a private key or another way to get special access to the smart contract code. Without a smart contract audit, they could use this to do something bad, like take control of the pooled funds.

Liquidity Pools Are Essential To the Operations Of DeFi Technology

A liquidity pool is an important component of DeFi. Even though it has its drawbacks, it helps carry out many DeFi activities like trading, crypto yield farming, lending, arbitrage trading, and profit-sharing. In addition, you can also get passive income by being a liquidity provider.

With liquidity pools, you can trade without the fear of market makers' price manipulation, increasing the trust that traders and liquidity providers have in cryptocurrencies and DeFi at large.