- DeFi Liquidity pools make it easier for buyers and sellers of cryptocurrencies to transact on DEXs
- Liquidity pools are, at their core, collections of crypto assets secured by smart contracts
- Decentralized exchanges heavily rely on Liquidity Pools to support trading activity.
- Although Ethereum-based liquidity pools paved the way, a new era of liquidity solutions is emerging in the Polkadot ecosystem. We will cover a few of these.
Most modern decentralized finance (DeFi) systems rely heavily on liquidity pools. They make it possible for some of the most widely used decentralized finance applications (dApps) to run and provide a means for crypto investors to generate income from their holdings. It is estimated that there are more than $30 billion in liquidity pools at the time of writing.
However, what exactly are liquidity pools, and how do they contribute to the DeFi landscape?
In this piece, we’ll discuss how liquidity pools operate and why they’re an integral part of the DeFi ecosystem. We’ll pay particular attention to liquidity pools within the context of the Polkadot ecosystem.
What is a liquidity pool?
Liquidity—in the context of financial markets—means that an asset can be sold or traded quickly and easily without adversely affecting its price.
One measure of liquidity is the ease with which an asset can be turned into cash.
The slower it is to trade an asset, or the slower it is to turn it into cash, the less liquid it is.
To facilitate transactions on a decentralized trading platform (DEX), crypto assets are pooled together to form a “liquidity pool.” A DEX is an open market where the exchange itself does not store users’ assets. Instead, DEX users trade with one another directly.
But decentralized exchanges need more liquidity than centralized exchanges because they have different ways for buyers and sellers to find each other.
Automated Market Makers (AMMs) are just math functions that set prices based on supply and demand and are used to solve this problem.
Because liquidity is crucial to how decentralized exchanges work, liquidity pools are essential to DEXs. By taking out loans, businesses can turn cash into debt or equity. In the same way, users create cryptocurrency escrow accounts when they lock their cryptocurrency into smart contracts that let others use it.
Liquidity pools are similar to online crowdfunding sites in that anyone can use them to store and withdraw cryptocurrency. Those who put money into this pool in exchange for liquidity will get a share of the transaction fees made when people use the system.
The DEX system would stand a standstill if AMMs couldn’t find buyers and sellers for assets.
Why are liquidity pools significant?
To facilitate peer-to-peer trading, DeFi relies heavily on liquidity pools. Several of the many uses of liquidity pools are outlined below.
Liquidity Pools make it easy for people to trade on Decentralized Exchange (DEX)
Decentralized exchanges cannot function without the liquidity provided by liquidity pools.
It would only be possible to trade digital assets on a DEX with them.
By letting users put digital assets into a pool and then trade the pool tokens on the DEX, liquidity pools give decentralized exchanges the liquidity they need to work.
Liquidity pools remove the need for intermediaries and a single point of control.
Automatic Market Makers (AMMs) determine prices and pair buyers and sellers in liquidity pools. Getting rid of centralized exchanges could make all business transactions more private and efficient.
Incentives are provided to liquidity providers.
LPs can use their digital assets to earn interest by participating in liquidity pools. By putting their tokens into a smart contract, users can get a share of the fees from trading in the pool.
This ensures that there is sufficient liquidity to facilitate trading on the DEX and incentivizes users to contribute to the pool.
What is the purpose of liquidity pools?
Liquidity pools are designed to make P2P trading on DEXs easier. Liquidity pools ensure that trades go quickly and smoothly by providing a steady flow of buyers and sellers.
To participate in yield farming (also known as “liquidity mining”), most DeFi users prefer to use liquidity pools as financial instruments. To put it briefly, yield farming provides liquidity to a pool in exchange for a cut of the fees created by trading activity.
However, yield farming is different from staking. In a future article, we will examine the difference between the two.
Superfluid staking is one step up in complexity. However, another ecosystem doesn’t get as much attention but has been growing significantly in recent years.
I’m talking about the Polkadot.
Specifically, I want to discuss liquidity pools and solutions in Polkadot’s DeFi ecosystem.
What are some examples of liquidity pools in Polkadot?
Acala is a stablecoin platform and a decentralized financial hub on Polkadot.
In addition to stablecoin and liquidity release protocols, the DEX trading platform, and prophecy machine, Acala also runs a cross-chain multi-asset collateralized stablecoin system.
Acala issues the derivative asset LDOT to free up the liquid resources of the committed platform token (its prior network, Karura, corresponds to LKSM).
The proposal strengthens the underlying derivative asset by adding LDOT as collateral to the stablecoin system and making it more liquid through the DEX.
Zenlink is a cross-chain DEX protocol that is built on Polkadot.
Its goal is to become Polkadot’s DEX composable hub. Zenlink DEX Protocol lets all parachains build DEXs and share liquidity with just one click.
It gives them access to the ultimate, open, and universal cross-chain DEX protocol based on Substrate. The Module, WASM, and EVM implementations in the Zenlink DEX Protocol are flexible and adaptable so that they can be put together in different ways and work with other DeFi modules.
Also, the Zenlink DEX Aggregator connects all DEX DApps on Polkadot and pools liquidity so that users can trade with low slippage.
Zenlink DEX Composable Hub lets developers use the Zenlink DEX Module to build their own unique DEXs. This creates a DEX composable hub for the Polkadot ecosystem.
At the moment, Zenlink has received two rounds of Web3 Foundation grants and investments from well-known organizations like Alameda Research, Hashkey, IOSG, OKEx Blockdream Ventures, and Hypersphere.
Polkaswap is a next-generation, cross-chain liquidity aggregator DEX technology for token exchanging based on Polkadot (and Kusama) network(s), Parachains, and bridged blockchains.
Polkaswap trades Ethereum-based tokens via bridge technologies. The SORA network makes non-custodial asset exchange seamless, fast, and cheap.
Polkaswap may trade against numerous liquidity sources using its liquidity aggregation mechanism.
The liquidity aggregator algorithm pools liquidity from multiple sources. AMM DEXs, order books, or other algorithms can provide liquidity.
Since Polkaswap is open-source, the community can add liquidity sources by working within the module. Polkaswap solves numerous important AMM DEX issues that no other DEX can.
Polkaswap’s liquidity infrastructure reduces temporary loss and pair slippage.
Polkaswap will be the first cross-chain, completely decentralized exchange with Ethereum and Bitcoin bridges, operating on a parachain and natively interoperable with the Polkadot and Kusama ecosystems.
HydraDX aims to revive Automated Market Makers (AMMs). They designed and developed the Omnipool over the past year to address capital inefficiency, which is the biggest drawback of traditional AMM models.
Liquidity fragmentation and unsustainable tokenomics contribute to classic AMM capital inefficiencies. Most AMMs that trade asset pairs have liquidity fragmentation as a design flaw. Unsustainable tokenomics is also caused by AMMs’ faulty architecture, which limits liquidity providers’ value.
HydraDX’s research group recently finished developing and validating the Omnipool, and their Substrate pallet is nearing completion.
Omnipool–as the name implies—eliminates liquidity fragmentation by pooling all trading assets. Deep and concentrated liquidity allows economic efficiencies like lower slippage and trading fees.
This unique, unrestricted AMM design is what permits the HydraDX team to develop HydraDX tokenomics sustainably.
Consolidating liquidity solves fragmented liquidity. Omnipool pools all assets to create deep liquidity.
Building a single AMM that supports several assets is complicated, which may be why this new yet intuitive AMM design has yet to gain widespread adoption.
Lerna (LRNA), HydraDX’s pool token, powers the Omnipool. When a liquidity provider adds or removes liquidity, LRNA tokens are produced or burned. LRNA’s supply swings with liquidity, helping balance the ecosystem.
Manta Network is another player innovating in the DeFi liquidity space on Polkadot.
It recently announced a two-week trusted setup event for its private payment app, with 5,000 participants from 133 countries. The event guarantees private transactions without posting personal data on the blockchain.
The tool, called MantaPay, privatizes crypto assets across Polkadot- and Kusama-based networks and lets users transfer and convert private assets to public assets.
MantaPay allows cross-chain private transactions for Polkadot ecosystem assets. The company said this includes privately sending DOT, KSM, ACA, wrapped BTC, or wrapped ETH to any Manta Network wallet address.
DAP uses zk-SNARKs. MantaPay lets users swap Polkadot/Kusama and other parachain or parathread tokens for anonymous tokens like Anonymous DOT, which can be used across the ecosystem and redeemed for a “real” underlying asset at any moment.
“We’re seeing much interest in our trustworthy setup—about 5,000 registrations. “I think it illustrates just how crucial privacy is for Web3, and the ecosystem understands that,” Manta Network co-founder and COO Kenny Li told Decrypt.
The milestone comes as the crypto business booms and users seek anonymity to protect their investments. Manta Network wants to provide its ZKP privacy technology to the whole Web3 ecosystem, the latest internet designed for open, trustless access.
What are the risks of liquidity pools?
There is always a chance of loss with any investment. Most notably, this is true for DeFi.
However, liquidity pools have recently grown in popularity, and more and more money is being invested in them. Because of the high stakes and expanding user base, more people than ever are working to ensure the security of user funds via well-coded smart contracts.
However, there are certain potential dangers that you should be aware of.
Faulty Smart Contracts
Liquidity pools face the threat of smart contract risk, one of the most severe threats in the industry. Here, we’re talking about the possibility that hackers will find a way to get into the pool’s governing smart contract.
There is a chance that hackers could find a flaw in the smart contract and use it to drain the liquidity pool completely. In the 2020 flash loan attack on the Balancer protocol, for example, the hacker used a flash loan to get a lot of tokens, which he then spent in a series of transactions that emptied the victim’s wallet.
So that investors are less likely to interact with a smart contract that could be hacked, they should only use liquidity pools that a reputable group has checked.
High Slippage Caused By Low Liquidity
Low cash on hand is another potential problem. Without sufficient liquidity, a pool’s trades may be subject to significant slippage.
This means a big difference between the transaction price and the price at which the trade was completed. This is because when the liquidity pool is low, even a small trade can change the way assets are used in a big way.
What do you do if you don’t want to stop interacting with the pool but can’t afford to fall in?
The good news is that most DEXs let you limit your slippage as a percentage of your deal. Be aware that the transaction could be delayed or even canceled if your slippage limit is too low.
If you and a group of others are minting a highly publicized NFT collection, you probably want to complete your transaction before all the assets in the collection are purchased. Increasing the allowed amount of slippage could be helpful in such situations.
Transaction Front Running
Front running is another typical threat. This happens when two users try to buy or sell the same asset simultaneously.
The first user can profit by buying the asset before the second and reselling it at a higher price. In this way, the first user can benefit at the expense of the second.
This often happens in slow networks and pools that don’t have enough money (because of slippage).
In the world of liquidity providers, the most common form of risk is the risk of impermanent loss.
It occurs whenever there is a rise or fall in the value of the underlying assets used to create the pool. This will cause the tokens in the pool to fluctuate in value.
The value of the tokens in the pool will fall in tandem with the price of the underlying assets.
Because there’s always a chance the underlying asset’s price could drop and never come back up, this is considered a risk. In such a scenario, the liquidity provider would lose money.
When the asset’s value grows dramatically, the loss may be temporary. This leads consumers to purchase from the liquidity pool at a lower price than the market and sell elsewhere.
The impermanent loss is the smallest in liquidity pools that contain low-volatility assets like stablecoins.
Liquidity pools are a core component of DeFi and are at the root of DEX trading. Even though Ethereum liquidity pools paved the way for DeFi, a new wave of liquidity pools is starting to appear in the Polkadot ecosystem.
To get started, try liquid staking on Algem today, and contribute your ASTR/nASTR pair to the Astar Network liquidity pools straight from our app!
Algem is a dApp built on Astar Network and offers two main features: liquid staking and liquid lending. As the name implies, these two solutions enable ASTR holders to remain liquid with their assets while putting them to work. In addition, the liquid staking and lending solutions allow users to accumulate staking rewards and increase their earnings using Algem’s liquid nASTR tokens across Astar’s Defi ecosystem. In doing so, Algem supports other Defi protocols by providing liquidity and creating a sustainable and cooperative ecosystem on Astar Network and Polkadot.
Start Using Liquidity Pools On Algem!
We launched nASTR Liquidity Hub on Algem, which means that you can now use liquidity pools from other dapps directly on Algem. The way it works is simple. Stake your ASTR tokens, then use your nASTR tokens and your ASTR tokens to add to a liquidity pool.