LIQUIDITY POOLS AND WHAT TO LOOK FOR IN ONE

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FODL

10 min readFeb 18, 2022

WHAT ARE LIQUIDITY POOLS?

Liquidity pools or LPs for short are in their essence collections of tokens that are locked in a smart contract. They are used to facilitate trading, borrowing/lending assets, yield farming, etc. Liquidity pools enable users to buy and sell crypto on decentralized exchanges such as:

Bancor, Uniswap, Curve, SushiSwap, QuickSwap, 1inch, Balancer, and many more

WHO CAN BECOME A LIQUIDITY PROVIDER?

Anyone can become a liquidity provider if they choose to, and in return, they usually receive a reward for doing so. They can do this by adding an equal value of two tokens to a pool that makes up a market.

ORDER BOOK MODEL VS. LIQUIDITY POOL MODEL

Unlike centralized exchanges (CEXs) which use the traditional electronic system of executing trades with an order book model and market makers that provide liquidity, most decentralized exchanges (DEXs) use the liquidity pool model and “automated market makers (AMM)” which we will discuss later on.

There are some DEXs such as Loopring and IDEX that use the traditional order book model however, they proved not to be so effective since they can be too expensive (network fees) for market makers to provide liquidity and therefore become illiquid as a result.

ORDER BOOK MODEL

Buyers and sellers place their orders in the order book. Buyers or “bidders” will want to buy assets for the lowest price possible. Sellers will naturally want to sell their assets for the highest price possible.

In order for a trade to be executed the seller needs to lower his “ask price” to the “bid price” of the buyer or the buyer needs to raise his “bid price” to the “ask price” of the seller.

Example of an order book:

BIDDER wants to buy $FODL at 0.20764 $USDT
SELLER wants to sell his $FODL at 0.21517 $USDT

What happens if none of them wants to change their price?

This is where “market makers” come into play. Market makers are entities that facilitate trading and are always willing to buy or sell assets. They close the gap between the “ask price” and the “bid price” and provide liquidity to ensure there are enough of these assets in the book for you to buy or sell.

They track the current global prices and are always adapting to them. This results in large numbers of orders being placed and canceled. It’s because of this fact that this model doesn’t make sense (although still possible) in the DeFi world which is built on smart contracts. For every order that the market makers would place or cancel, smart contracts would have to be deployed and network fees would need to be paid for the miners to approve them. This would make the process very slow and expensive (especially on the Ethereum network) for now. Not what you want for an efficient market.

LIQUIDITY POOL MODEL

In its basic form, a liquidity pool usually consists of a pair (can be more) of tokens, and each pool creates a market for this particular pair of tokens.

The creator of a pool which is also the first liquidity provider sets the initial price of the two assets in the pool. He/she is incentivized to supply an equal value of both assets.

If the initial price of the tokens in the pool diverges from the global price it creates an instant arbitrage opportunity that can result in lost capital for the liquidity provider. This concept for supplying the two tokens in a correct ratio remains the same for the rest of the liquidity providers who are willing to add more funds to the pool later.

In exchange for providing liquidity to a pool, the liquidity providers receive LP tokens which are usually the protocol's native token (eg. $Sushi token on SushiSwap/ $Uni token on UniSwap, etc.). Liquidity providers receive these tokens as a reward in proportion to how much liquidity they supplied to a given pool.

When a trade is facilitated by the pool a percentage (usually around 0.03%) of the trade fee is proportionately distributed amongst all the LP token holders. If a liquidity provider wants to get their underlying liquidity back plus the fees they need to “burn” their LP tokens.

Each token swap that the liquidity pool facilitates results in a price adjustment according to a deterministic algorithm. This algorithm is called an “automated market maker (AMM)”. Liquidity pools in different protocols may use AMM’s that differ slightly.

When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool. The bigger the pool the lesser the price impact (slippage) for any executed trade.

Example of a liquidity pool:

0xb1’s Kitchen Sink liquidity pool 127 on Rari Capital’s Fuse protocol

0xb1 Kitchen Sink on Rari Capital’s Fuse protocol

To see how to supply xFODL to this liquidity pool you can click this:
HOW TO LEND OR BORROW xFODL ON RARI CAPITAL’S FUSE POOLS

RISKS REGARDING LIQUIDITY POOLS

IMPERMANENT LOSS

Impermanent loss occurs when the price ratio of the deposited tokens changes after the liquidity provider deposits them. The more volatile the price of one of these tokens is the greater the risk of impermanent loss.

Price ratios of the two tokens should always be correct and constant in a pool to avoid this problem. If significant price imbalances occur, arbitrage traders will be quick to capitalize on them and close the gap. This will leave the initial liquidity provider with a loss of a portion of his/her assets if they decide to withdraw their funds from the pool at that particular moment. It is called “impermanent” because if the ratio of the price retracts to the same value as before the loss is canceled out.

This is why AMMs work best with token pairs that have a similar value, such as stablecoins or wrapped tokens. If the price ratio between the pair remains in a relatively small range, the impermanent loss can be negligible.

If you want to know more details about impermanent loss, check out this detailed article: Pintail’s article

WAY TO MITIGATE IMPERMANENT LOSS

Bancor Safe Staking

Although there is no way to completely eliminate impermanent loss due to volatility of assets, there is a way to mitigate it according to Bancor. They came up with a concept called “Bancor Safe Staking” which allows your funds to be “principal protected”. This means that whatever amount of funds you provide to a liquidity pool on Bancor, they assure you that you will receive at least the same amount when you decide to exit that particular pool.

This allows you to maintain 100% long exposure with the token that you provide and collect swap fee rewards that auto-compound. Bancor also allows you to provide a single token, unlike most other protocols that require at least a pair.

How does it work?

When you deposit a token other than BNT to one of their pools, Bancor invests in the same pool with their native BNT token and matches the amount of your deposit. They consider it a co-investment and of course, they can profit from it the same way as any other liquidity provider (swap fee rewards).

They take the profit they make from collecting rewards and use it to cover your impermanent loss when you decide to exit the pool. When you decide to pull your stake out, they burn the matching amount of their initial BNT invested.

Example:

If you deposit $10.000 worth of ETH -> Bancor deposits $10.000 worth of BNT

However, there are some requirements for you to be eligible for 100% compensation for your impermanent loss.

In order to be eligible for 100% compensation, your funds will have to stay in the pool for at least 100 days. This concept is basically like an insurance policy on your funds and it increases at the rate of 1% per day. 100 days equals 100%.

What if you want to pull your funds out earlier?

The minimum time for holding the position needs to exceed 30 days for you to be eligible for any compensation, so roughly a month. If you want to withdraw your position prior to these 30 days you will not receive any.

After these 30 days have elapsed you will receive the compensation in proportion to the stake duration. Meaning if you have held the position for 50 days, you will receive 50% compensation, etc.

SMART CONTRACT BUGS AND MALICIOUS CODE

Although the concept of smart contracts is very innovative and useful, they can contain bugs. We have to remember it is people who are making these smart contracts and we all know people can make mistakes intentionally or unintentionally. Sometimes unexpected problems may occur, so you have to be mindful of this when considering depositing your funds to a liquidity pool.

The DeFi ecosystem is designed in a way so, that no one has control over keeping data or the funds and this gives hackers an opportunity to exploit. While on a centralized platform such as a CEX, hacker's accounts can be frozen, on a DEX no one can do this.

WHAT TO LOOK FOR IN A LIQUIDITY POOL

Before you decide to provide your funds to a liquidity pool, you should learn everything you can about it. Look for any inconsistencies or reports online by other liquidity providers. If you have programming knowledge go ahead and audit the code in the smart contracts yourself. If something bad happens, you won’t be able to blame anyone but yourself, so do your research properly!

CREDIBILITY OF POOLS AND PROTOCOLS

Platforms should guarantee that they are functioning under the latest industry solutions and employ a strong security system to reduce the risk of hacker attacks.

For example, a poor security solution resulted in a money withdrawal made by the head of SushiSwap. In September 2020, Chef Nomi unilaterally withdrew one-quarter of the project’s developer funding pool, a sum worth more than $13 mln at that time, causing major controversy in the crypto community. Following the ensuing accusations of fraud, Chef Nomi returned the funds and made an apology.

HIGH VOLUME

As we established earlier, a liquidity provider is incentivized by rewards (% of trading fees of the protocol) to provide liquidity. More volume equals more trading fees which equals more profit for the liquidity providers.

RESERVES

Higher reserves mean better liquidity which results in less slippage (price swings) when executing trades. Because DEXs use AMMs to execute trades you can only swap tokens via market orders (limit orders are not possible). These are always subjected to some price swings. To minimize this high liquidity is needed.

The lower the reserves, the more the pool is susceptible to price slippage, which means the price ratio will move. Again, not good for liquidity providers because they get subjected to impermanent loss as we discussed earlier.

Another good idea is to check the pool is not made up of only a few whales since they can affect the price ratios should they exit the pool.

VOLUME/RESERVES

Knowing this ratio will help liquidity providers get a sense of the APY rate they should expect going forward. The number should be increasing or at least remain constant for a good LP setup.

CONCLUSION

Liquidity pools have become one of the most crucial parts of the DeFi ecosystem, and we should all try to understand how they work so we can use them to our advantage. Essentially they are the backbone of decentralized finance.

Providing liquidity to a pool can be a good instrument to put your crypto funds to work if you’re not actively trading them. However, if you don’t know how to do it properly, you can find yourself losing money. By reading articles like this one you are on the right track of educating yourself enough to be profitable in this space. Keep it up, and read many more if you can!

Hope this helped you in any way friend! Cheers!

“Disclaimer: This article is not trading or investment advice. The above article is for informational and educational purposes only. Please do your own research before purchasing or investing in any cryptocurrency or digital asset.”