Liquidity pools - Basic concepts

Decentralized Finance (DeFi) has emerged as a rapidly growing sector of increasing importance in the global financial landscape. Positioned as an innovative alternative to the traditional financial system, DeFi leverages blockchain technology and cryptocurrencies to enable individuals, businesses, and other entities to conduct financial transactions directly peer to peer (p2p), eliminating the need for centralized intermediaries such as banks.

At the heart of this financial revolution are liquidity pools, which form the fundamental infrastructure enabling the efficient operation of decentralized exchanges (DEXs). These pools facilitate the continuous trading of digital assets without reliance on complex order books or the intervention of central authorities. A detailed understanding of the mechanisms governing liquidity pools is therefore crucial for any active participant or stakeholder in the DeFi ecosystem. The rise of DeFi represents a fundamental shift in the financial sector, and liquidity pools are essential to this transformation, enabling peer-to-peer trading and a variety of other financial services.

The growing adoption of DeFi reflects an increasing demand for alternative financial systems. Understanding liquidity pools is vital for navigating DeFi effectively, as these pools power a wide range of decentralized applications beyond DEXs. Lending protocols, perpetual DEX platforms, and yield farming, for instance, also rely on the liquidity provided by these pools.

What Are Liquidity Pools? (Overview)

A liquidity pool can be formally defined as a collection of digital funds typically pairs of cryptocurrencies or tokens locked in a smart contract. Its primary function is to facilitate the decentralized trading of digital assets directly between users. Unlike traditional exchanges, liquidity pools eliminate the need for complex order books, where buyers and sellers must be matched, and remove the requirement for central authorities to validate and settle transactions.

Automated Market Makers (AMMs) play a pivotal role in managing these pools. They are protocols that algorithmically determine asset prices based on supply and demand within the pool. Instead of relying on an order book, where prices are set by bids and offers, AMMs use mathematical formulas to adjust prices in real time, ensuring liquidity is always available for trading.

In contrast to traditional centralized exchanges, which use order books to match buyers and sellers, liquidity pools offer several advantages. They are permissionless, meaning anyone can participate without approval. They operate 24/7, allowing trading at any time. Additionally, they have the potential for greater efficiency and lower fees. The shift from order books to AMMs represents a fundamental innovation in market design, enabling continuous liquidity and peer-to-peer trading in a decentralized manner.

The accessibility of liquidity pools lowers the entry barrier for both traders and market makers, democratizing participation in financial markets. Anyone can become a liquidity provider with any amount of capital, and traders can execute swaps directly from their wallets without relying on a third-party entity like a centralized exchange.

How Liquidity Pools Work on Uniswap V2

The operation of a liquidity pool begins with its creation. This typically involves an interaction with a specific smart contract for a given token pair (e.g., ETH/USDC) and the initial funding of the pool by individuals or entities interested in providing liquidity.

Smart contracts are essential to the automated management of liquidity pools. They execute the predefined trading rules of the protocol, calculate asset prices based on specific algorithms, and transparently and immutably distribute transaction fees among liquidity providers. One of the biggest challenge for any decentraized application team is the security of its smart contracts.

When we look to liquidity, one of the foundational formulas in liquidity pools is the constant product formula, expressed as:

                                  x * y = k        

The Constant Product Formula

In this equation, "x" and "y" represent the quantities of the two distinct tokens that constitute a liquidity pool, while "k" is a constant value that must be maintained to ensure the pool’s stability and predictability. This formula determines the exchange rate between the two tokens.

For example, if a user wants to swap ETH for USDC in an ETH/USDC pool, the formula ensures that the trade adjusts the quantities of ETH and USDC in such a way that the product of their amounts remains constant. If the quantity of ETH in the pool decreases due to a purchase, the quantity of USDC must increase proportionally to keep "k" unchanged, resulting in a higher price for ETH relative to USDC.

Price Discovery Mechanism

The price discovery mechanism within liquidity pools is intrinsically tied to this formula. The price of one token relative to the other is determined by their ratio in the pool. The more a token is bought, the scarcer it becomes in the pool, driving its price up relative to the other token. Conversely, if a token is sold in large quantities, its supply in the pool increases, and its price decreases relative to the paired token.

The constant product formula guarantees that liquidity is always available for trading, though potentially at a less favorable price for large trades, preventing the pool from being completely drained of one asset. As the supply of a token diminishes, its price increases exponentially according to the formula, making it progressively more expensive to acquire the remaining tokens. This incentivizes traders to halt purchases before the pool is exhausted.

Price discovery in liquidity pools is purely driven by supply and demand within the pool itself, creating opportunities for arbitrageurs to align these prices with those on other DEXs. If an asset’s price in a liquidity pool deviates significantly from the broader market price, arbitrageurs will trade to profit from the discrepancy, simultaneously bringing the pool’s price back in line with the wider market.

Liquidity Providers (LPs): Key Players

Liquidity providers (LPs) are individuals or entities that play a critical role in the DeFi ecosystem. They deposit tokens into a liquidity pool, enabling trading for other users. The primary motivation for LPs is earning a share of the transaction fees generated by trades executed in the pool.

When creating a liquidity pool, key parameters are defined:

• The percentage fee LPs earn per transaction.
• The price range (full-range or specific range [Uniswap V3]).
• The amount of each token to allocate.

Each time a trade occurs in the pool, a small fee is charged and distributed proportionally among LPs based on their share of the total liquidity. In return for their deposits, LPs receive these accumulated fees for the duration of their participation.

Beyond transaction fees, LPs may also be incentivized through additional rewards, such as governance tokens from the protocol. This practice, known as yield farming or liquidity mining, further encourages participation by rewarding users not only with trading fees but also with tokens that may hold value or confer voting rights in the protocol’s governance.

The Role of LPs in DeFi

Liquidity providers act as decentralized market makers, playing a vital role in the health and efficiency of DeFi ecosystems by ensuring sufficient liquidity for trading. Without LPs, DEXs would suffer from low liquidity, leading to high slippage and hindered trading. LPs effectively supply the capital needed for seamless transactions.

LP Tokens: Proof of Ownership and Utility

LP tokens represent a user’s stake in a liquidity pool and serve as proof of ownership to reclaim deposited funds. These tokens are versatile assets within the DeFi space. Beyond enabling LPs to withdraw their initial deposits and earned fees, LP tokens can be used across various decentralized applications, enhancing their utility and potential returns.

Curiosity of an advanced use cases: Collateralizing LP Tokens

Today, LP tokens can even be used as collateral to borrow stablecoins like USDC. In other words, while a liquidity pool holds a provider’s funds, earning fees from users swapping between two tokens, the LP tokens representing that position can be collateralized to secure a loan in dollars (e.g., USDC).

Once the loan is initiated, the borrowed capital can be deployed in numerous ways. One example is hedging against potential impermanent loss in the original pool. Below is an image illustrating a real-world application of this mechanism.

Introducing Uniswap V3

Uniswap V3 stands out as one of the most innovative and widely used decentralized trading protocols in the DeFi space. One of its key distinguishing features is the introduction of concentrated liquidity. This innovation allows liquidity providers (LPs) to allocate their capital within specific price ranges rather than distributing it across the entire price curve (from zero to infinity) as in V1 and V2.

By concentrating liquidity around current market prices or within ranges where higher trading activity is expected, LPs can significantly improve capital efficiency and potentially earn higher returns on their assets. In few weeks i'll write an artice about Uniswap V3 with more details.

Fee Tiers in Uniswap V3

Uniswap V3 offers different fee tiers that can be set for different trading pairs. These tiers—typically ranging from 0.01%, 0.05%, 0.3%, to 1%—are determined based on the volatility and perceived risk of the assets in the pair:

• Low-volatility pairs (e.g., stablecoin/stablecoin like USDC/USDT) often have lower fees (0.01%–0.05%) to encourage high-volume trading.
• High-volatility pairs (e.g., ETH/altcoins like ETH/LINK) usually have higher fees (0.3%–1%) to compensate LPs for the increased risk of impermanent loss.

How Fees Are Collected and Distributed

Transaction fees are collected on every trade executed on Uniswap V3. These fees are then distributed proportionally to liquidity providers who supplied liquidity within the price range where the trade occurred.

• If the market price of a token pair moves outside an LP’s specified range, their liquidity becomes inactive and stops earning fees until the price re-enters their range.
• But, when the price is within their range, LPs earn fees on every swap, enhancing their potential returns.

Advantages of Concentrated Liquidity

1. Capital Efficiency – LPs can provide deeper liquidity with less capital by focusing on key price ranges.
2. Better Price Execution – Traders experience lower slippage when executing large orders within active liquidity zones.
3. Dynamic Fee Structures – Different fee tiers align incentives between traders and LPs, leading to more efficient and robust markets.

Real-World Example: A USDC/WBTC Liquidity Pool

The image below shows a randomly selected liquidity pool as an illustrative example, a USDC/WBTC pool on Uniswap V3 with:

• Fee tier: 0.3%
• Price range: 102,214.00 to 118,044.00 USDC/WBTC
• Value invested: approximatly 9300.00 $

How It Works:

• As long as Bitcoin’s price stays within this range, the LP earns a share of all swap fees generated between USDC and WBTC.
• At the time of this snapshot, the LP had accumulated $19.79 in fees waiting to be claimed.
• Fees are distributed 50% in USDC and 50% in WBTC aproximatly, ensuring balanced exposure.

The Greatest Enemy of LPs: Impermanent Loss

Impermanent Loss (IL) is a critical concept that every liquidity provider (LP) in DeFi must understand. It refers to the temporary loss in value of assets deposited into a liquidity pool compared to simply holding those assets outside the pool. This loss is called "impermanent" because it can be reversed if the token prices return to their original levels at the time of deposit.

What Causes Impermanent Loss?

The primary driver of impermanent loss is price divergence between the two tokens in a liquidity pair. Automated Market Makers (AMMs) like Uniswap V2 use the constant product formula (x × y = k) to automatically rebalance the pool after each trade. If the price of one token in the pair increases or decreases significantly, the pool adjusts the quantities of both tokens to maintain equilibrium. When an LP withdraws their assets, they may receive a different ratio of tokens than they initially deposited, resulting in a lower total value than if they had simply held the tokens.

Example:

Consider an ETH/USDC pool where ETH’s price rises sharply:

1. The AMM automatically sells some ETH and buys USDC to maintain balance.
2. When the LP withdraws, they receive less ETH and more USDC than they deposited.
3. The total value of their withdrawn assets may be lower than if they had just held ETH and USDC separately.

Calculating Impermanent Loss - Uniswap V2

The magnitude of impermanent loss can be estimated using a mathematical formula based on the price change ratio between the two tokens. A common equation for IL is:

                     IL = [2 * sqrt(P)] / [(1 + P) - 1]          

Key Observations:

✔ Higher price volatility → Greater IL risk ✔

IL is minimized if prices return to their initial state. Fees earned can offset (or exceed) IL in active pools.

Impermanent loss is an inherent risk in liquidity provision, but understanding its mechanics allows LPs to make informed decisions. While IL can reduce returns, well-structured pools with high trading volume can generate enough fees to outweigh potential losses.

                     IL = [2 * sqrt(P)] / [(1 + P) - 1]          

Where P represents the ratio between the final price and the initial price of one of the tokens in the pair.

Practical Example: ETH/USDC Pool on Uniswap V2

Let’s assume:

• You deposit 1 ETH at $1,000 + 1,000 USDC → Total: $2,000
• Initial ETH price = $1,000 (so, 1 ETH = 1,000 USDC)
• After some time, ETH rises to $2,000

So,

P= 2000 / 1000 = 2         

Step 1: Calculate Impermanente Loss

IL= 1 - [2 * sqrt(P)] / [(1 + P)] = 1 - [2 * sqrt(2)] / [(1 + 2)] = 0.0572        

That is, an impermanent loss of ~5.72% compared to simply holding the assets outside the pool.

There are important strategies that LPs can employ to mitigate the risk of impermanent loss. LPs may choose to use hedging tools to offset potential losses arising from price volatility by leveraging other dapps. Impermanent loss is a fundamental risk for liquidity providers, and its magnitude is directly correlated with the volatility of the paired assets. Understanding this risk is crucial for making informed decisions about providing liquidity. Highly volatile assets can lead to significant price divergence, resulting in a substantial impermanent loss that may outweigh the fees earned. Although termed "impermanent," the loss becomes permanent if the liquidity provider withdraws their assets while the price divergence persists, highlighting the importance of a long-term perspective or strategic timing for withdrawals. If the asset prices eventually return to their original ratio, the "loss" disappears. However, if an LP needs to withdraw funds when prices have significantly diverged, the loss will be realized.

The Vital Role of Liquidity Pools in the Future of DeFi

In summary, liquidity pools represent a fundamental component in the architecture of Decentralized Finance, enabling permissionless and efficient trading of a wide range of digital assets. By pooling funds from various liquidity providers into smart contracts, decentralized exchanges can operate without the need for traditional intermediaries or complex order books, using AMMs, also known as Automated Market Makers.

Liquidity providers are incentivized to participate through the distribution of transaction fees and, in some cases, additional token rewards. However, it is crucial that participants are aware of the concept of impermanent loss, an inherent risk in liquidity provision that can result in temporary value losses due to asset price volatility. Ongoing innovation in the DeFi space is leading to the evolution of liquidity pool mechanisms. Features such as concentrated liquidity introduced by Uniswap V3, the exploration of dynamic fees and hooks introduced by Uniswap V4 (the latest version launched) demonstrate the potential to address existing challenges such as impermanent loss, and to further optimize capital efficiency for liquidity providers.

Liquidity plays a vital role in the health and stability of the cryptocurrency market as a whole, ensuring smooth trade execution, reducing price volatility, and attracting a broader range of participants, including institutional investors. As the DeFi ecosystem continues to expand and mature, liquidity pools will remain at the forefront of financial innovation, offering new opportunities and challenges.

Below are two very simple charts showing the increase in liquidity that has been taking place in recent years. This is a clear sign of growing institutional adoption.