Pools of Liquidity in DeFi

Updated: Nov 12, 2021

Another great video from Finematics (check out his website here), this time on LPs (Liquidity Pools). Per the video, these are pools of tokens locked in smart contracts and are used to facilitate trading by providing liquidity. This is done via DEXs (Decentralised Exchanges).

Finametics goes through the reason that LPs are needed. It breaks things down to the order book model which exchanges like Coinbase and Binance go through which is similar to traditional finance. We see the need to match buyers bids to sellers asks in our work on ETFs (via ETFtracker) where we track market data to see bid/ask spread info. This is fine when there are willing buyers and sellers but when there isn't, there is a need for market makers.

The need for market makers is the same in DeFi and crypto but if the model was to be fully replicated it would not be great as the traditional order book model always needs market makers to stay liquid. Market makers need to buy at any price and so are constantly changing prices which means lots of cancelled orders as not all are filled. Replicating this given current processing times on Ethereum network, as well as the gas fees, would not make this viable if it were made the same way. Liquidity Pools were built to address these issues and make things work for this area in the DeFi space.

The second half of the video goes through how Liquidity Pools work. It is based on token pairs like DAI/ETH. The initial LPs will st the price and are, like real world market makers, incentivised to provide supply when needed to the market. Other LPs who come on board will also come in and inititial and subsequent LPs will provide the same amount of token pairs, like DAI/ETH or others. LPs receive LP tokens for the tokens they provide to the pool and there is also an additional fee provided (in the example 0.3%) and if they want to get liquidity back they burn LP tokens. This is where (AMMs) Automated Market Makers come in where a price adjustment occurs to account for LP tokens being taken out. It's all done deterministically with different algorithms done by different DAOs. These algorithms help to ensure there is enough liquidity in the pool after various actions.

All of this sums up with the lack of a need of a centralised order book and external market makers constantly providing liquidity to an exchange. Variations of the UniSwap idea here such as Balancer and Curve found better ways to do have LPs for different asset types to ensure smoother trading in their DAOs and we're sure there are more coming.

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