Liquidity Pool

Market Insights Mar 11, 2021

A core technology behind DEXs

Decentralised Finance (DeFI) is on the hype and has shown an explosive growth in the recent past months, as mentioned in our article Decentralised Finance. Most of the different forms of DeFi applications, such as payments, lending, tokenisation and decentralised exchange (DEX) are on the rise.

One of the core technologies behind DEXs is the Liquidity Pool, that we will discuss in this memo.

Since September 2020, the DEX to CEX trade volume growth rate has subdued. Nevertheless, since January 2019, when the concept of DEX was just emerging, the ratio has increased steadily and is now at almost 10%.

DEX market volume for the month of February represented $72.9 billion with a large concentration on a few actors, including Uniswap and Sushiswap who respectively hold 50% and 20% of the market share.  As of the 10th of March, DEX month-to-date volume was $21.3 billion.

A liquidity pool is the backbone of many DEXs and is used to facilitate decentralised trading, lending, and other functions. Users, called liquidity providers (LP), add tokens in a pool to create a market and, in exchange for providing their funds, earn trading fees from the trades that happen in their pool. The reward is proportional to their share of the total liquidity.

In a centralised exchange (CEX), a classic order book can be seen as a peer-to-peer contract, where buyers and sellers are connected by the order book.

In a DEX, on the other end, it is more like a peer-to-contract approach. When a trade is executed on an Automated Marker Maker (AMM), you don’t have a counterparty but instead you are 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. Your activity is managed by the algorithm that governs what happens in the pool. In addition, pricing is also determined by this algorithm based on the trades that happen in the pool.

In exchange for providing their funds, liquidity providers earn trading fees and/or coins from the trades that happen in their pool, proportional to their share of the total liquidity. New minted tokens are distributed algorithmically to users who put their tokens into a liquidity pool. Participating in a pool allows a crypto owner to get compensation even in the absence of price appreciation, which brings a tangible utility to digital assets.

Liquidity pools are the innovation that gave some breath into DEX and helped them compete with CEX.

Some popular DEXs that use liquidity pools

One of the first protocols to use liquidity pools was Bancor, but the concept gained more attention with the popularisation of Uniswap. Some other popular exchanges that use liquidity pools on Ethereum are SushiSwap, Curve and Balancer. Liquidity pools in these places contain ERC-20 tokens. The similar equivalents on Binance Smart Chain (BSC) are PancakeSwap, BakerySwap and BurgerSwap, where the pools contain BEP-20 tokens.

Some of those exchanges have their own characteristics: Balancer, for example, has increased the number of possible assets in the pool from 2, like Uniswap, to 8. This allows large asset options to be exchanged so that liquidity providers can earn higher rewards.

Another interesting project is Curve. To reduce the inherent risks of volatility and slippage when trading digital assets, Curve implemented liquidity pools with stablecoins, as a result of which the exchange rate in the pools practically does not change. Slippage refers to the difference between the expected price of a trade and the price at which the trade is executed.

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Caroline Jacquard

Seasoned marketing manager with 15+ years of experience in the financial industry: traditional finance, alternative investment and digital assets. Advisor