What Are Liquidity Pools?

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Why, as a P2P Investor, do you need to know about Liquidity Pools?

Liquidity pools are an important part of DeFi or decentralized finance. If you read our recent article on CeFi vs DeFi, then you may have seen this term before.

The fastest-growing area of lending, and p2p investment opportunities, is in DeFi. And the foundation of how we lend in DeFi is through liquidity pools. First, let’s do a quick glossary for those of you new to this term and DeFi so we can be sure we are talking about the same things. Then we will do a deep dive showing why it’s important to know these terms and this market.

Short Glossary

  • DeFi-decentralized finance. Lending platforms in the cryptoeconomy that don’t have a central point of failure or are not run by a single company. Euro p2p platforms like Twino are centralized, and they can approve or reject transactions.
  • Smart contract. A self-executing pre-programmed contract(s) that includes collateral and terms that have to be satisfied to fulfill the contract. Otherwise, the collateral is returned.
  • Order Book. The way most trading exchanges and brokerages operate by showing you what assets are available at what price. For example, the market price of Bitcoin might be $59,000, but the order book shows there’s 0.2 BTC available at that price but 1.5 BTC available at $59,400 if you want to buy more than 0.2 at that price instead.
  • Liquidity Pool (LP). A place where people can lend their assets to provide liquidity to a market. In a related context, LP can mean liquidity provider too, which is you, the lender, providing liquidity to a market in a pool to earn interest.
  • Trading Pairs. A trading pair is a pair of assets you can trade with or against each other. Barclays Bank stock (BARC) is a trading pair of BARC/GBP because you exchange Pounds for Barclays Bank stock. Whether you have GBP, EUR, or USD, every investment you make is a trading pair since you are exchanging the currency for the asset.

Liquidity Pools vs Order Books

To understand what liquidity pools are, we need to understand how they differ from typical order book exchanges.

Go to any exchange, whether it’s:

  • Fidelity and Schwab for US stocks
  • Hargreaves for UK stocks or 
  • Coinbase or Binance for Bitcoin and cryptocurrency

They all have one thing in common. They organize their exchanges by order books. With crypto exchanges, you can see the supply and the prices they are willing to sell their Bitcoin to you. Almost as important, you can see the other buy orders trying to buy Bitcoin at the same time you are trying to buy yours. With stock exchanges, sometimes you can see the order book, and sometimes you can’t. But it’s there balancing sellers and buyers.

This is what Binance’s order book looks like for the Bitcoin-Tether trading pair (click the link to open a Binance account so you can trade in cryptocurrencies, options, futures, and p2p trading).

Picture showing the trading pair, BTC/USDT

As you can see, the prices and supply are listed right there for a buyer or seller to see. The red numbers (which you see are slightly higher than the price of $57,521) are the sell orders. Someone is willing to sell 0.034 BTC for ~$2000. The green orders are buy orders, so someone is willing to buy 1.899 BTC for $57,521 or a total of $109,254 for the order.

So what does this have to do with liquidity pools? More than you might think.

All these exchanges are centralized financial operations (CeFi). If there is not enough supply of an asset for the buyers, the exchange might step in and supply some of the stock or cryptocurrency themselves. Many brokers in US stocks trade for their own accounts both as an extra source of revenue and to provide liquidity to markets by being a market maker.

DeFi exchanges automate this function. PancakeSwap, in our example below, is an example of an AMM or automated market maker. They use algorithms to maintain prices in any particular trading pair based on how much liquidity that pair has. By only providing liquidity for automated market making, an AMM and its lenders (liquidity providers like us) have incentives aligned. The app and the lenders share the exchange fees that others pay to buy or sell the crypto. And PancakeSwap, or another AMM, cannot step in and make a market for themselves to earn more in fees without others knowing since the smart contracts are kept on-chain for everyone to see. We show you how to look on-chain with block explorers below.

So how does a DeFi exchange know how much supply they have of an asset? If they don’t have an order book, how do they know how much crypto they have?

Liquidity Pools = Consistent Supply

The answer is DeFi exchanges know how much of a cryptocurrency they have based on liquidity pools. In a liquidity pool, two crypto assets are pooled together to create a trading pair, as discussed above, with trading GBP for Barclays Bank stock.

Ethereum is the largest blockchain for DeFi. In this example on the Binance Smart Chain, CAKE, the token for PancakeSwap (the biggest DeFi market on the Smart Chain) is paired together with BNB, the Binance token.

Picture showing the liquidity pool CAKE-BNB LP

You see that the name of the liquidity pool (LP) is CAKE-BNB LP. Its current liquidity is $697 million. And how does it know? Where it says view contract, that’s the smart contract that everyone uses that deposits funds into this pool. You can easily audit the pool to see what is in there and see how big your stake in the pool is based on your investment. On Binance Smart Chain, you audit using BSCScan, the Binance Block Explorer. Here’s the one for CAKE.

Because it’s a trading pair, when we invest in a liquidity pool, we are putting in equal USD amounts of both assets. When you click on the Get CAKE-BNB LP, this is what you see:

Picture showing the screen when you click

That plus sign you see means we have to add both assets in equal amounts, and the current market prices CAKE at 23.17 per BNB.

Buyers and sellers take advantage of this liquidity to buy and sell CAKE for BNB. As purchases and sales take place, the price of both assets will change. Imagine we had 10 BNB and 230 CAKE (because 23 to 1) in our LP. Now someone sells 50 CAKE for BNB, which means we now have more CAKE and less BNB in the LP than before. The pair rebalances, and we have 280 CAKE and 7.85 (10 – 2.15) BNB. The price adjusts automatically to encourage buys to get back to the desired ratio of CAKE to BNB. And it’s all automated.

As a p2p investor, liquidity pools may not matter to you. You don’t care about these assets. You just want to lend and make money. Well, here’s why liquidity pool investing is worth your time.

You get a share of all the transaction fees generated by the purchase or sale of this trading pair. More than 95% of transaction fees after exchange fees are distributed to the LPs.

Back to that first image above on the liquidity pool, you may have seen that huge 79.85% APR. Well, that’s a ridiculously high interest rate, as we all know. That rate comes from three places:

  1. The transaction fees this trade generates.
  2. Paying you for your liquidity knowing you could use your asset in some other way. It’s a way to compare the return of this LP to other LP investment options. The higher the APR, the more they need your liquidity and are willing to pay for it.
  3. And knowing the price of the underlying tokens (in this case CAKE) can and will fluctuate, so the high APR helps make up for some of that.

At the time of writing, the transaction fees, which you can see on this wallet address on PancakeSwap, are $716,896 over the last 24 hours and a daily volume of $358 million.

Picture showing the cake-wbnb trading pair

As a contributor of liquidity to this trading pair, you get some of this $716,896 in proportion to your investment. Others want to buy or sell CAKE or BNB, and you are helping them. Your liquidity lowers the prices they pay, so they pay you in the transaction fees. You and your liquidity pool are playing the role of the market maker.

As you can see by these fees, this is a big, active market. Many other liquidity pool markets are much smaller than this, but you have complete control over which markets you invest in. Bigger markets like this are generally safer investments than some that look no different from being at the roulette wheel – the more assets and the more extensive the network in DeFi, often the safer the investment. But not always, and your research and due diligence are required.

The important thing is you get to decide once you understand how these liquidity pools work. Fully decentralized exchanges have many liquidity pools for lots of different trading pairs. They can offer the combination of the best assets and the best pricing available for buyers or sellers.

Conclusion

In conventional markets like the US, UK, or Shanghai stock markets, the only people who get to provide liquidity and make markets for stock buyers and sellers are huge trading firms. And they make huge money from it both in trading fees and on being on the right side of the trade where they made a market.

In DeFi with liquidity pools, you get to be the one who provides liquidity and makes money. You don’t get trading income as Citi or Credit Suisse does, but you don’t take the trading risk either. You get to lend your assets to a market that wants it, it is huge and often much larger than Euro-based p2p platforms, and you can earn well above Euro or USD-based interest rates for doing so.

If you want to make money from p2p lending in the long term, then DeFi and the cryptoeconomy is a market you have to learn about for both now and the future. Liquidity pool investing needs to have a place in your p2p portfolio. As with all lending, there is the risk of losing your capital, and risks are higher in DeFi markets. That’s why you earn more here. Only a small portion of your portfolio should go into these markets until you understand them VERY well. But like Forex, gold, or commodities, there is a place for DeFi lending in your portfolio once you understand the risks.