What Roles do Liquidity Pools Play in Decentralised Finance (DeFi): Explained

The decentralized finance (DeFi) sector aims to remove intermediaries like central banks and brokers from financial transactions, focusing mainly on crypto-based services. In this article, we’ll explore liquidity pools, often described as the driving force behind the smooth operation of DeFi protocols. Liquidity pools allow users to quickly convert assets into cash, accelerating transaction processes and ensuring the seamless functioning of these crypto-driven systems.

How are Liquidity Pools Formed

Liquidity pools are like reservoirs of cryptocurrencies locked within blockchain-based smart contracts. Anyone can become a “liquidity provider” for a DeFi protocol by depositing their crypto tokens into these smart contracts, pooling their assets alongside those of other participants. Each LP needs to deposit token pairs in equal values and in return, LPs get rewarded with LP tokens or LP NFTs.

Investors using a DeFi protocol can directly exchange their tokens with fiat currencies or other cryptocurrencies through the liquidity pool linked to the protocol.

Decentralised exchanges (DEXs) rely on liquidity pools to maintain stability in operations.

Usecases and Advantages of Liquidity Pools

As mentioned before, liquidity pools incentivise depositors with tradeable LP tokens or NFTs.

In a recently published blog, Binance noted that liquidity pools allow investors using DEXs to exchange their tokens round the clock. This contrasts with the functioning of centralised exchanges wherein the availability of buyers and sellers can limit the number of transactions.

Crypto assets are volatile in nature and since DeFi protocols completely deal around crypto transactions – they could be more suspectable to the impacts of market fluctuations. Because liquidity pools maintain large collections of tokens, they keep the volatility of DeFi protocols in check. In a wider picture, this prevents DeFi protocols from undergoing extreme market instability.

Risks Associated with Liquidity Pools

Financial services centered around virtual digital assets (VDAs) like crypto tokens and NFTs are constantly exposed to risks from regulatory changes and macroeconomic factors.

Investors in liquidity pools may face financial losses if the tokens they’ve locked in smart contracts experience a sharp decline in value. Without being locked, investors would have the flexibility to sell their tokens before incurring significant losses.

As per blockchain audit firm ImmuneBytes, smart contract vulnerabilities, such as coding errors and cyber-attacks, can lead to the loss of tokens for depositors.

Liquidity pools are also susceptible to flash loan attacks, where attackers borrow large sums of assets temporarily to manipulate trades, causing disruptions to the protocols.

Market analysts recommend that investors only participate in liquidity pools through reputable platforms. On decentralised exchanges like SushiSwap, Curve, Balancer, Uniswap, and PancakeSwap, users can connect their wallets, select a pair of tokens, and contribute to the liquidity pool.