The liquidity pools are the main mechanism in DEX (decentralised exchange) that fills customer request books as a substitute for centralized exchanges. The question of what exactly centralizes exchange arises in our minds. The exchange is responsible for users’ spot currency buy and sell orders at one point when the order is triggered.
Let’s suppose what will happen when trading activity is less than that day that cannot fulfill an agreement. Sometimes buyers want to buy at the lowest price possible, and sellers try to sell as high as possible in a trading order that is not equal to the volume of orders available on the other side. The liquidity pool comes into the task. It helps to support market liquidity by buying and selling a specific number of assets.
Today, liquidity pools are an imaginative game plan within decentralized money to create market mechanics in a decentralized manner. LP’s are pools of tokens that are locked up in a smart contract. The liquidity pool is the most effective leveling device for Web 3.0 and decentralized monetary development in computerized innovation.
Bancor launched it the first time, and then Uniswap made it widely recognizable. A liquidity pool is a type of common market creator that grows by distributing resources to those who contribute. This article will provide some key information about the liquidity pool.
What are liquidity pools in crypto
In order to understand liquidity pools, we need to gain some perspective on the term “liquidity.” The term is used in the crypto realm to describe the ease with which any coin can be moved around or converted into cash or other coins without difficulty.
Liquidity pools in crypto are decentralised reservoirs or vaults of coins which have been locked under smart contracts to ensure the liquidity of those coins on a decentralised exchange system.
The tokens or coins in the Liquidity Pool (LP) are contributed by the liquidity pool depositors. They are one of the most important innovations of the decentralised finance (DeFi) ecosystem. LPs are a fundamental feature of decentralised exchanges (DEX) such as Uniswap. LPs are used to facilitate decentralised trading, lending, and borrowing, etc. in the crypto world.
Liquidity pools have replaced the order book model used in stock markets and centralized cryptocurrency exchanges, which relied on a seller and a buyer for a trade to happen and used the concept of selling and asking price.
The transaction in such a system requires buyers and sellers to agree upon a price in order for the trade to happen. LPs have replaced this concept of a market maker and a supply-demand imbalance with automatically adjusted market makers that automatically adjust the value of tokens as per the imbalance in the pool. Liquidity pools in crypto have been a blessing for people wanting to trade and invest efficiently and free of any protocol obstruction.
Is the liquidity pool worth it
Liquidity pools are definitely worth it as they make the crypto industry more accessible and fluent to trade across. It streamlines the trading process by removing the need for a third party within the trading chain.
LPs are also used for yield farming or liquidity mining. Many of the liquidity pools on the market provide incentives to providers to ensure that the pools remain large and full, thereby reducing the danger of any slippages and providing a better trading experience for online traders. They are the key components of automated yield generating platforms such as Yearn, where users can add their funds to liquidity pools, which are then further used to generate yields on the coins.
However, there are some risks associated with LPs, such as temporary loss, hacking, fake tokens, or a decline in the value of tokens in the pool.Apart from these, there are risks relating to the smart contract itself.
The coins deposited in an LP are locked under a Smart Contract, which means they become the custodians of those coins.
In a situation where there is a discovery of a bug or an exploit in the algorithm, the coins deposited could be lost forever. Further, there are risks involved with the terms and conditions of any particular liquidity pool. One needs to be careful about volatile pools where the admin is allowed to make changes in T & Cs as they please.
In such cases, they might end up taking control of coins within the pool, causing losses. Therefore, it is always advised to read the rules and regulations before investing in any liquidity pools. It is advisable to invest in LPs trusted by the leading and most stable cryptocurrencies.
How Liquidity Pools Work
Unlike in mainstream financial markets where the liquidity is controlled by market makers, liquidity pools in crypto use Automated Market Makers (AMM), which allow digital assets to be traded in an automatic fashion through the use of liquidity providers. AMMs allow for on-chain trading without the demand for customer request books.
There are no direct counterparties involved, and the exchange rates are finalized through the complex algorithm of the pool. The complexity and security of the code are what define the reliability and immunity of the pool from being compromised and being trusted.
The pool consists of an equal number of token pairs in a 50:50 ratio, and the algorithm is designed to keep the value of the pool balanced. For example, if Token A is being bought at a faster rate by giving Token B into the pool, the algorithm will automatically detect a higher demand and raise the value of Token A each time it is purchased.
This lowers the value of Token B as it detects that the demand for token B is higher because of the large amounts of token B in the pool, so to balance it, token A gets expensive and token B gets cheaper.
Within the LPs, there are incentives for the liquidity providers to invest. Each provider gets new coins that represent their invested stake within the pool, called a “pool token.”
These tokens are the other tokens that were present in the pool. Further incentives include the trading fees collected by the AMMs from the pool. T
hese are automatically distributed among the liquidity providers depending on their stake size in the LP. If a provider wants to withdraw their investment from their pool, they can do so by giving away their stake back into the pool, creating a balance in the pool.
Are liquidity pools profitable
From an objective point of view, liquidity pools seem like a great investment, but despite the popularity of liquidity pools in the crypto industry, they have their pros and cons like any other trading mechanism. Liquidity pools provide a greater interest per annum as compared to order books and mainstream financial trades. However, there is a catch to it; the profitability or the interest per annum are not constant in the LPs and they depend on many factors.
The amount of interest collected from the pool depends on the size of the pool itself. The larger the size of the pool, the lower the interest per annum. Therefore, one has to keep track of their investments periodically.
Apart from this, there are always risks involved, such as ending up with fake tokens. Due to no KYCs done on liquidity pools, there is a possibility of fake tokens being present and, therefore, if one ends up with such tokens and the token is flagged, the value of such tokens falls exponentially and there are chances of huge losses.
In the end, liquidity pools will be more profitable for people who have expertise in this complex crypto market and who consider different scenarios. In order to participate in liquidity pools, one has to analyze their assets and needs to have a feel for the market phases.
Can liquidity pools be hacked
As with all other facilities on the internet, one ponders whether this vast reservoir of tokens is vulnerable and can be hacked. In one word, yes. Liquidity pools are hackable. At their basic core, liquidity pools are lines of code, an algorithm to facilitate a form of trading.
These lines of code can be exploited through bugs identified in them. One of the various ways in which liquidity pools can be hacked is rug pulling. In such a case, a large amount of liquidity is removed from the pool, which causes the liquidity providers to suddenly withdraw their investments to save whatever profits they can. In Rug Pulls, hackers remove all digital traces as they stop their attack. This is a very low-risk, high-return attack for the hackers and is therefore the most popular attack on LPs.
Other common occurrences of hacking are arbitrage and flash loans. These are mostly used to manipulate the pricing of the pool in order to gain from the same liquidity pool or create a flush within the pool to gain from another pool. If one looks at the recent events,
it’s clear that liquidity pools are hackable and are susceptible to vulnerabilities like all entities in the digital world. The following incidents lay out how liquidity pools have been targeted and hacked in the recent past. In 2020 alone, losses of more than $100 million have been reported in some of the liquidity pools due to attacks on loopholes within the pool’s code.
Another such recent incident of hacking involved the Balancer Pool, which fell victim to an exploitation of a loophole that involved tricking the algorithm protocol to release tokens worth $500,000. The hacker took advantage of the Statera (STA) token’s transfer fee model that reduced the value of its token by 1% per trade. The attacker interfered in the Balancer Pools trade involving WETH and STA almost 24 times and drained STA’s liquidity pool value to nothing.
Liquidity pools protocols have undoubtedly shown innovation and great potential within the crypto industry and will probably shape the future of trading. However, they are still on their onset and are very new to the industry and its protocols for smart contracts. Therefore, it is always advisable to research and assess the market properly and only get involved with trusted liquidity pools. But that is not to say that they aren’t hackable.