How To Become a Crypto Banker With Liquidity Pools

Noah Fields
Noah Fields


How To Become a Crypto Banker With Liquidity Pools
Table of Contents
Table of Contents

The decentralized finance (DeFi) sector is growing at an exponential rate. The reason for this is largely centered around liquidity pools (smart contract-based protocols) and liquidity providers (end users who provide capital). Here's how liquidity works in DeFi.

Since the inception of decentralized finance (DeFi), liquidity has been a driving factor for user adoption. DeFi is a concept that combines both liquidity pools and liquidity providers, making it possible for anyone to become a virtual bank. Users deposit and lend funds in order to produce higher Average Percentage Yields (APYs) than traditionally available through banks. There are now hundreds of DeFi protocols reproducing all the functions of a bank on a blockchain.

In 2019, the value locked in these protocols was less than $1 billion. In late 2021, it is over $110 billion, a monumental increase in a relatively short amount of time. Find out how such an economic explosion happened.

Value locked in DeFi
Value locked in DeFi protocols by category, image credit: The Block

Liquidity Explained

To first understand what a liquidity pool is, we must be clear about the importance of liquidity itself. Whenever traders enter any market, they rely on the market's liquidity. Without available liquidity, it is much harder to buy and sell assets, with potentially either side seeing unfavorable price conditions based on demand. Case in point, the real estate market has low liquidity. Why?

Each house has unique properties alongside being a verified and ownable asset; this makes houses non-fungible, as they cannot be interchanged with other houses. In fact, houses are so low in liquidity that they are commonly referred to as illiquid assets. Likewise, if you were to try to sell an NFT (non-fungible token), that sale would depend on the market's liquidity — is there a demand for that particular kind of asset at that particular moment in time?

Now, when we move into fungible assets — fiat money and cryptocurrencies — liquidity is inherently higher. The reason for this is apparent, as the assets are easily interchangeable. Liquidity is the measure by which one asset can be exchanged for another of equal value. Because both USD and BTC can be fractionalized, one into cents and the other into SATS, this means they can be exchanged with a near-zero price difference.

However, there are few institutional market makers to provide liquidity within the blockchain space. For instance, JP Morgan, the world's largest bank, is also a market maker (a.k.a. liquidity provider) when it comes to exchanging currencies on the forex market, holding a 10% market share, but not for cryptocurrencies.

If you were to exchange USD for EUR, a market maker like JP Morgan would be the intermediary that would give a quote for ask and bid prices as well as supply liquidity. Without liquidity, traders would have to wait for their orders to be fulfilled until counter-party traders make the matching offer. By that time, the price of the asset itself might shift! This is where liquidity pools come in to replace such centralized market maker mediators.

Market makers (liquidity providers) provide liquidity on both the buy side and sell side of a trade.

What Is a Liquidity Pool?

If you've been reading carefully so far, you already see where this is going. In the blockchain space, there are no institutions like JP Morgan or Citadel Securities to that act as a liquidity provider, leaving that duty up to everyday users looking to optimize their ROI. Decentralized Finance (DeFi) relies on users, cryptography, and smart contracts to create liquidity. Specifically, smart contracts create DeFi liquidity pools.

A liquidity pool is a kind of smart contract application deployed on a blockchain, mimicking a bank's process of giving interest in exchange for depositing assets. What happens when you deposit your cash to a bank? This money becomes available for the bank to use for its lending programs and other investments. In return for providing the bank with that cash, you gain an interest rate (although vanishingly small in traditional finance compared to DeFi). Many mainstream banks will offer around 0.1% interest on deposited assets, with some banks even charging customers to store their money! Using liquidity pools, users can see significantly higher returns, even by staking stablecoins such as $USDT and $USDC.

Therefore, when you deposit your crypto funds into a DeFi liquidity pool, you effectively become both ends of a bank. This is the power of decentralized finance! Now, your funds are locked into the liquidity pool for a specified time, and other traders can tap into them, either for trading between token pairs or borrowing.

As you would expect, any time you lock your crypto funds into a liquidity pool, you become a liquidity provider (LP). This is the essence of yield farming, with liquidity pools as yield farms and liquidity providers as yield farmers.

How Does a Liquidity Pool Work?

There are many popular liquidity pools powered by decentralized exchanges across different blockchain networks. On Binance Smart Chain, PancakeSwap is the most popular, while on Ethereum, SushiSwap exchange, Uniswap, Maker, Curve, and others hold the bulk of the market share.

Total value locked in DeFi by protocol
Total value locked in DeFi by protocol

Let's take the Uniswap exchange as an example, one of the oldest, most established, and well-known decentralized exchanges, largely responsible for pioneering and popularizing the concept of liquidity pools as the backbone of decentralized finance. If we head over to Uniswap Liquidity Pools and list the ranking by trading volume, we would get a predictable outcome. The most popular liquidity pools consist of token pairs involving stablecoins and ETH, Ethereum's native coin (and the second-largest cryptocurrency). Ethereum is also the largest smart contract platform with the greatest number of dApps and NFT marketplaces.

Uniswap liquidity pools
Top liquidity pools on Uniswap

Because people need to convert from crypto to fiat and vice versa, stablecoins are always a hot commodity. They avoid inherent crypto volatility while still being crypto assets that offer all the benefits of blockchain technology. If we enter the USDC/ETH liquidity pool, we get all the info needed to become liquidity providers.

Uniswap liquidity pool - USDC/ETH
USDC/ETH liquidity pool on Uniswap

As you can see, 161.63 million USDC (equal to USD) is available to exchange for 12.91k ETH, and vice versa. If you were to connect to that liquidity pool via a MetaMask wallet, you would add liquidity to both sides of the trading wall. For this valuable service as a liquidity provider, you earn APY (annual percentage yield), drastically higher than one can achieve in any bank savings account with near-zero interest rates.

However, automated market makers like Uniswap do have some issues. One concept many traders on lower liquidity trading pairs face is known as slippage. Slippage is the difference between the expected price and the actual price once the transacted exchange is completed, meaning value can be lost for traders.

Furthermore, one should be wary of impermanent loss, a potential byproduct of providing liquidity to a LP pool and having one of the tokens go up in value. In this case, you may get less of the valuable token (although the same cash value as you initially deposited), introducing additional risk.

Is It Worth It To Become a Liquidity Provider?

Given that central banks have forced commercial banks to set negative interest rates across Europe, it is no wonder that DeFi protocols have experienced such explosive growth in under two years. If you have ever wondered where to stake your crypto assets, DeFi is a growing sector with plenty of great options to choose from. Although becoming a liquidity provider can be risky, as the old adage goes, "No risk, no reward."

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