Liquidity Pools

Definition

A liquidity pool is a group of funds bound by a smart contract. The terms of the smart contract determine the utility of the funds in a specific liquidity pool. The most common use-case for a liquidity pool is facilitating token swaps on a decentralized exchange.

All you need to know

You can do a lot of things when you have a pool of money. DeFi projects reward users who contribute to their pool of money that is used to provide financial services, like token swaps, derivative exchanges, and lending platforms.

There are endless ways for a project to utilize a liquidity pool. Some common applications include token swapping, lending, and creating yield for users through a range of financial products. Normally these tasks would require the funds of a central authority, like a bank or brokerage. These central authorities have the limitations of hidden fees, delayed transactions, and KYC (know your customer) requirements. However, any of these tasks can function in a decentralized and transparent way by using funds contributed to a liquidity pool and governed by smart contracts. Many DeFi projects are open-source and all transactions take place on the blockchain for all to see. Moreover, liquidity pools are often permissionless, meaning anyone can contribute (or provide liquidity) to the project and take part in the profits or incentives. Does being permissionless increase the risk of DeFi? While there are always risks involved in digital assets, high-quality DeFi projects are designed to have straightforward smart contracts that protect liquidity providers.

The liquidity pool is the backbone of a DeFi protocol. Therefore, a project will often incentivize people to contribute to their liquidity pool. Rewards for being a liquidity provider include earning a share of rewards, fixed emissions from the project’s locked token supply, and voting rights (also known as governance). Before depositing your funds into a liquidity pool, you should thoroughly review the project, the terms of the smart, and the rewards you earn by participating.

Example 1: The most common use of a Liquidity Pool is when a decentralized exchange (DEX) uses liquidity pools to allow users to swap between two tokens. Liquidity providers contribute two tokens in equal value to a liquidity pool, such as the DFL-USDC liquidity pool on Raydium. When someone uses the liquidity pool to swap between USDC and DFL tokens, they pay a small transaction fee. This transaction fee is distributed among liquidity providers to reward them for their contribution to the liquidity pool.

Example 2: A lending protocol has a native token. The lending protocol allows users to stake their tokens in a liquidity pool. This liquidity pool is used for collateral when distributing funds, and all stakers obtain voting rights to approve or disapprove of the loans. When stakers vote to approve a loan, they earn a percent of the interest on the loan.