Liquidity pools are an essential component of a functioning crypto ecosystem. Despite their importance in supporting decentralized finance (DeFi), it’s still a relatively new technological development that’s being fine-tuned each and every year.
Liquidity pools function like companies behind crypto exchanges, however, their ownership is decentralized, rather than centralized like an exchange such as FTX or Binance. Centralized exchanges provide liquidity for their userbases to trade with on the platform, and the company earns revenue through the fees generated by trades. By contrast, a liquidity pool lives on a decentralized exchange (DEX). It is made up of willing participants who provide their own liquidity to the pool, and as traders swap tokens on the decentralized exchange, the fees are distributed to liquidity providers, rather than a centralized company.
As the world becomes increasingly decentralized, liquidity pools are progressing this decentralization by giving the average person more ways to participate in a global market.
Why are Liquidity Pools Important in Crypto?
Liquidity pools are vital to the crypto ecosystem because they serve as the backbone for decentralized exchanges. They are integral for these main reasons:
- Enabling token swapping: Without users depositing their own liquidity into liquidity pools on DEXs, traders would not be able to swap tokens in decentralized finance (DeFi) protocols, which would massively stunt the growth of crypto projects and hinder them from experiencing price discovery in the market.
- Supporting DeFi functionality: Not only does token swapping allow for a healthy trading market and proper price discovery of digital assets, but it also enables DeFi projects to function properly as they typically require different tokens to operate. In order to enable token swapping in DeFi, decentralized exchanges need liquidity.
Without these measures in place, the decentralized financial ecosystem would have no mechanism to transfer cash from the real world into the crypto industry. Therefore, liquidity pools and the users participating in them build the foundation for an emerging and flourishing market.
How do Crypto Liquidity Pools Work?
A liquidity pool functions by applying what’s known as the automated market maker (AMM) system to a decentralized exchange. The AMM enables a participant, known as a liquidity provider, to deposit equal amounts of two different digital assets into a liquidity pool, such as Solana (SOL) and USDC. Every pair of swappable tokens on a decentralized exchange needs to have liquidity to enable trading.
Liquidity pools directly impact the price of tokens. With high amounts of liquidity in a pool, there is much higher volume and thus less volatility. However, the lower the amount of liquidity there is in a pool, the easier it is to move the price of the asset as it takes much less volume to affect a token’s price. This phenomenon is known as slippage.
Traders aim to reduce the amount of slippage as much as possible when conducting trades so that they can get the best prices possible for opening a trade. This is why large players in the market will spread their capital over many trades; if they were to spend all of their capital all at once, it would likely push the price higher or lower, depending on if they bought or sold, as their orders are getting filled.
Aside from legal requirements, institutional players usually buy on centralized exchanges because they can handle large transactions due to their high amounts of liquidity.
Yield Farming and Liquidity Pools
Obviously, no one wants to give up their own digital assets as liquidity for others to trade with, unless there is incentive for doing so. Liquidity pools create incentive by generating fees from trades on the decentralized exchange. These fees are then distributed to the liquidity providers for giving their service to the decentralized exchange. This process is known as yield farming, as liquidity providers are ‘planting’ their assets into a liquidity pool to yield returns over time.
Depending on which liquidity pool you use, yield is paid out in two variable rates:
- APR: The annual percentage rate (APR) shows the rate of return for yield farmers without
- APY: The annual percentage yield (APY) measures the rate of return for yield farmers with
If a yield farm offers 10% APR compared to another farm which offers 10% APY, the APY-based yield farm will reap more returns over time, as that rate accounts for compounding returns.
The Value of Crypto Liquidity Pools
Not only do liquidity pools provide the support needed for DeFi protocols, but they incentivize more users to participate in supporting the industry by generating yield for liquidity providers.
FTX is one of the largest centralized crypto exchanges on the market that offers a gateway into the decentralized financial ecosystem. Aside from enabling users to trade tokens used for liquidity pools in decentralized exchanges, FTX also allows users to support crypto through its backstop liquidity provider program.
The FTT DAO is a community of like-minded FTX fans supporting the exchange’s mission to promote effective altruism. With every trade made on the FTX platform, the exchange contributes 1% of the trading fees to investments in humanitarian-focused projects. To get involved without needing to use real money, consider joining the FTT DAO and become a BFF today!