Why is Liquidity Pool important & How does it work in DeFi?

In the DeFi ecosystem, liquidity pools serve as the beating heart of decentralized exchanges and lending platforms. These pools are where users contribute their tokens, enabling seamless trading, borrowing, and lending. But why are they crucial, and how do they work? Let’s dive into this blog to find answers!

What is a Liquidity Pool?

A liquidity pool is a collection of cryptocurrencies or tokens locked in a smart contract. This pool facilitates trading between these assets on decentralized exchanges (DEXs). It creates liquidity for transactions with the help of automated market makers (AMMs), which allow for the seamless and autonomous exchange of digital assets.

People who provide their tokens into liquidity pools are known as liquidity providers (LPs). LPs will receive LP tokens when providing liquidity to the pool and can use these tokens across various DeFi platforms.

👉Learn more about AMM and its role in boosting liquidity: All About AMM — Automated Market Maker

The importance of Liquidity Pools

When a market has low liquidity, it leads to high slippage — a large difference between the expected price and the executed price of a token. This often happens during volatile market conditions or when large orders exceed available trading volume.

Another scenario is when you want to swap an amount of token A to token B (e.g. USDC/USDT pair) on a protocol with low liquidity. This could result in the actual exchange rate you receive could be lower than the expected rate or you can not sell the tokens.

Liquidity pools aim to address this illiquid issue by rewarding users with a portion of trading fees for contributing assets to the pool.

How do Liquidity Pools work?

As mentioned above, DeFi protocols encourage LPs to stake their assets in the pool and reward them with cryptocurrencies or a share of trading fees from exchanges where they pool their assets. When adding to liquidity pools, LPs have to deposit equal values of two tokens into the pool.

We will give you an example to make this clearer:

If you want to provide $1000 in a USDC/USDT pool using Thorn Protocol, you need to:

• Deposit a 50/50 split of USDC and USDT to that pool ($500 USDC and $500 USDT in this case)
• Once your deposit is confirmed, you’ll receive a reward consisting of a share of the trading fees generated by USDC/USDT swaps in the pool

🌹For a step-by-step guide on providing liquidity to Thorn Protocol, you can check out our tutorial video on X @thorn_protocol HERE.

What happens after you provide liquidity?

Various protocols offer additional rewards for specific “incentivized” pools to enhance the trading experience. By contributing to incentivized liquidity pools, users can be able to earn the maximum amount of LP tokens, which is known as Liquidity Mining.

And then, many different DeFi markets and platforms allow users to earn rewards for providing and mining liquidity through LP tokens.

So how do LPs know where to place their funds?

Subsequently, there is another term coming in: Yield Farming. This involves staking or locking up assets within a blockchain protocol to generate tokenized rewards; and when LPs stake or lock up tokens in various DeFi protocols, they can maximize their earnings.

Are liquidity pools safe?

Impermanent loss is the primary concern for all LPs in DeFi. It can occur when the asset prices in a liquidity pool change significantly from the time LPs initially deposited them.

The potential for loss stems from the fact that LPs must add an equal value of the two tokens in the liquidity pool.

The worst-case scenario comes when one token becomes more volatile and expensive than the other. If the volatile token’s price surges outside a liquidity pool (called X), arbitrage traders will take advantage of the price difference. They buy the lower-priced tokens from X and sell them at the higher external market price. As a result, the volatile token’s price inside X increases, leaving X with less of that token.

As the liquidity pool tries to maintain an equilibrium between the two tokens, LPs will hold less of the now valuable token. If that liquidity provider sells now, the impermanent loss would become permanent.

However, impermanent loss is often negligible in pools with high volume and low volatility such as those involving stablecoins.

Conclusion

Attracting liquidity is a challenging endeavor when investors prioritize high returns. Nevertheless, as a foundational component of the contemporary DeFi infrastructure, these technologies already help enable decentralized trading, lending, yield farming, and numerous other applications.

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Thorn Protocol is the pioneering Stableswap platform that offers private trading and cross-chain utility, all empowered by our AI Wallet.

Our core objective is to make the trading of stablecoins and volatile assets more cost-effective and seamless while ensuring the principles of transparency and decentralization.

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