Liquidity Pools: What They Are, How They Work, and Where You Can Find Them
One of the foundational components behind decentralised finance (DeFi) is the concept of liquidity pools. Rather than relying on centralised order books, where a specific seller is needed for a sale and vice versa, liquidity pools allow for on-demand trades from these pooled assets.
Built as a public interoperability platform for the DLT industry, hashport enables users to access and/or contribute to liquidity pairs that reside on foreign networks to their own.
Introduction to Decentralised Finance (DeFi)
DeFi at its core is a solution that cuts out the gatekeepers and middlemen from financial transactions. Banks and other financial institutions are able to dictate how long your money takes to get from point A to point B (and what fees to charge you along the way). However, a financial instrument built on top of the DeFi ecosystem contains all the instructions it needs written right into its code to accomplish disintermediated transactions. As a starting point, think of deposits, loans, insurance, and securities trading. When the conditions of the financial instrument (often a ‘smart contract’) are met, the required actions are automatically triggered. DeFi instruments are typically fast, secure, and inclusive.
Now to liquidity pools (known as automated market makers, or AMMs)…
When users commit to pooling their assets, they provide liquidity that can be used for a number of different financial purposes, usually built out on dApps (decentralised applications). And the powerful thing about this is that it’s not just big companies that are able to provide liquidity in DeFi — anybody can. With the advent of DeFi and smart contracts, everyday investors can become market makers, alongside much larger players to help drive innovation and earn a fair compensation for doing so.
Liquidity providers contribute an equal value of two tokens to a liquidity pool, thereby increasing the volume of the pool. For their contribution, LP providers receive a portion of the fees generated from trades within that specific pool in proportion to their share of the pool.
Unlike traditional crypto markets, liquidity pools do not have an order book where a peer makes purchases. Instead, liquidity pools use automatic market makers (AMMs), which are algorithms governing the activity of the pool. The AMM determines the price, depending on the ratio of assets in the pool, meaning a “peer” seller is not required — there needs only to be sufficient liquidity in the pool for the transaction to be effected.
The pool’s asset liquidity means traders are able to swap between different tokens and know the trade will receive fair market value within the confines of the pools they are transacting with. Liquidity pools make trading fast, convenient and more reliable in comparison with trading via Market Makers.
Types of Staking
With liquidity pooling, there are various ways that token holders can benefit. Single and dual-sided staking are two of these ways. Single-sided staking is used to support and govern the development of a protocol, providing insurance to its growth. Dual-sided staking, or liquidity pooling, provides a source for other users to invest via trading tokens.
Let us elaborate and share some examples.
Single Sided-Staking: support and development of new projects
One form of supporting the development of new projects that use a proof of stake model instead of a proof of work model is single-sided staking. Users are promised the ability to earn additional tokens of that same staked asset in return for committing their tokens for a certain period of time. When users redeem their tokens, they are guaranteed that they will recover their entire deposited amount without impermanent loss, as well as receive their additional reward tokens to compensate for locking up their principal amount.
Some protocols also allow those who stake their tokens to participate in the governance of the protocol, contributing to decisions on future changes and upgrades to the protocol.
Ultimately, single-sided staking allows users to support their favourite projects and earn passive income at the same time.
Examples of major cryptocurrencies that users can stake include Ethereum, Cardano, Polkadot and Solana.
Double-Sided Staking (also known as liquidity pooling)
Double-sided staking is the process of providing liquidity to a pool: think of platforms such as Uniswap, Sushiswap, Balancer or Quickswap.
Taking a step beyond supporting and providing a form of insurance to a protocol via staking, double-sided staking opens a world of decentralised finance possibilities via dApps that facilitate payments, securities trading, and more.
As an example, Uniswap’s LP (Liquidity Pool) tokens can be used as collateral across DeFi.
Uniswap facilitates pools with 2 tokens, while Balancer takes it further and allows 8 tokens in a single pool. All pools rely on the ratio of tokens within the pool to dictate the price. For instance, if someone has invested in a DAI/ETH pool and buys ETH from the pool, the supply of ETH in that pool is reduced and the supply of DAI, in proportion, is increased. Hence, size matters. The bigger pools are less impacted by the size of a trade; price is not such an issue and less slippage will occur.
The value of the tokens in liquidity pools is calculated via an algorithm, one example is the constant product formula first used by the Uniswap protocol. The constant product formula draws on a simple x * y = k to maintain that each pair of tokens stays at equal total values.
Using such algorithms to fix token prices in a constant state is what enables reliable smart contracts and automated trades to occur without relying on the traditional market makers that require order books, buyers AND sellers.
Lock in Vaults
A Lock in Vault places a time-release condition on the staking of tokens. Until the predetermined time, holders of coins held in these types of instruments cannot do anything with them. The vault operates in a similar manner to how a fixed-term investment operates within traditional markets. By agreeing to stake assets for longer periods of time, participants are rewarded with more lucrative returns.
A given staking pool may also come with an unstaking period. These can last anywhere from 7–14 days (or longer) so it’s important for users to know what a given platform’s unstaking period is, if any, at the outset. Unstaking periods, (also known as a cooldown or unbonding periods) serve to guard against large, sudden changes in network and token prices as a whole.
Participants will need to wait until the end of the specified cooldown period before they can transfer out their tokens.
Cooldown periods can also vary even on the same token depending on which network the token is staked upon. For example, Polkadot’s cooldown period is 28 days, but if staked via Kusama (Polkadot’s pre-production environment) it is only 7 days.
Liquidity Pool Risks:
It’s essential for users to weigh the risks of Liquidity Pooling and/or Staking before investing. These risks vary between DeFi models.
Impermanent Loss Risk
When you consider providing liquidity to an automated market maker (AMM), it is essential to be aware of the potential for impermanent loss.
Impermanent loss occurs if the token price you invested in changes while your assets are locked up, meaning you would have been better off just HODLing the tokens. Impermanent loss only becomes permanent if a user withdraws their liquidity at a time in which the price of their underlying assets is different to the price of those same assets when they contributed them to the Liquidity Pool.
Smart Contract Risk
Automatic market makers (smart contracts) can be vulnerable to hackers, and with no gatekeeper, a hacked system could mean that a user could lose all of their funds. A good practice for users is to ensure that the protocols they are interacting with have had rigorous security audits on their code bases to ensure platform integrity.
Exit scams, also known as rug pulls, are not unheard of in the crypto industry. Find out before you invest in a given platform whether the developers are able to alter the rules of the liquidity pool(s) you are interested in joining. You don’t want someone able to assume control of the pooled funds.
The value of a cryptocurrency portfolio can be boosted when funds are staked or farmed. Still, it’s important to be aware of the conditions that pools operate under and whether the developers can clean the funds out of the holding accounts.
Starting with a small investment is a smart approach, and as trust is built with a given platform, users can scale up their total investment.
As you can see, there is a significant upside to partaking in liquidity pooling and staking; the range of options available to users is continually increasing. With the industry still in its infancy innovation is a constant almost daily occurrence in the space. Those who take the time to understand the concepts of DeFi, Liquidity Pooling, and Staking, while also being mindful of the risks stand to take advantage of a generational opportunity.
hashport will help create worlds of opportunity for users by giving them secure, timely, cost-effective access to emergent DLT markets and platforms in order to capitalise on them as they arise.
hashport is the enterprise-grade public utility that facilitates the movement of digital assets between distributed networks, extending their functionality in a quick, secure, and cost-effective way. In order to remain platform-neutral, hashport functions without the use of a proprietary token. The network is built on a robust and performant architecture, secured and operated by a group of industry-leading validator partners from around the world. hashport has passed a rigorous security audit and follows industry best practices; regularly performing comprehensive network tests to ensure the integrity of the network.