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Liquidity Pools and their importance for DeFi projects

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Liquidity is one of, if not the number one most important aspect of any market. While new crypto investors and traders are more concerned with roadmaps, utility or partnerships, market veterans are hesitant to enter the market unless liquidity is sufficient. They know something the rest don’t.

Liquidity – the availability of liquid assets to a market or company.

The reason liquidity is so important is because it largely affects how the price of an asset will move. In a low liquidity market there’s a very small amount of available orders on both sides of the order book. This means that one trade could move the price dramatically in either direction, rendering illiquid markets unstable and unattractive. 

Poor liquidity is a risk

Low liquidity markets are essentially balancing on a tightrope. One small move from one direction can cause drastic changes. This scares off big players because it puts their capital at greater risk. Furthermore, no one is able to offload a big position into an illiquid market without slippage. Instead of taking on that risk, it’s safer to just avoid the market altogether. 

Cryptocurrency especially suffers from liquidity issues due to the nascent nature of the industry, huge amounts of digital assets with even more trading pairs and the sheer number of competing exchanges. Overall liquidity is poor, but the current market dynamics silo liquidity into exchanges and trading pairs which further reduces liquidity available to traders. It doesn’t matter how much Bitcoin liquidity is out there because it’s split between thousands of exchanges and heaps of trading pairs. 

For cryptocurrency to become a more attractive financial market liquidity needs to drastically improve. This is why there are multiple ongoing projects aiming to leverage the potential of distributed ledger technology to create decentralized liquidity pools. Let’s take a look. 

What are decentralized liquidity pools?

A liquidity pool is a broad term used to refer to cryptocurrency projects that are designed to enhance liquidity by creating a large pool of liquidity which allows swapping between assets instead of having set trading pairs. There are many ways to tackle the problem, so the best way to understand this area is to study the current market leaders to see their approach and results.

Uniswap

Uniswap is a completely decentralized automated liquidity protocol based on Ethereum. You can use Uniswap to trade between ETH or ERC-20 tokens on-chain. However, it’s what goes on behind the scenes to boost liquidity which is interesting. 

Uniswap is a bunch of smart contracts that hold reserves of different ERC-20 tokens. People are able to become liquidity providers by depositing tokens to Uniswap in exchange for pool tokens, which are used to track how much has been deposited to the pool by each person. Pool tokens can be redeemed at any time. Liquidity providers are entitled to a pro-rata share of the 0.3% trading fee paid on Uniswap. This incentivizes people to become liquidity providers and helps to continue growing the pools. When trading occurs automation within the smart contracts ensures that liquidity is maintained throughout the pools. 

ICTE

ICTE is a decentralized cross blockchain exchange that has recently launched. Within this model includes a product designed to enhance liquidity. This is achieved by creating decentralized global liquidity books, which is then further enhanced by multi-blockchain order matching. 

Bancor

Bancor is a blockchain protocol that you can use to swap between cryptocurrency assets. The network is designed to bring liquidity to all tokens, not just Bitcoin and Ethereum, which is commonly the case in crypto. Bancor uses smart tokens and smart contracts to convert between ERC-20 tokens. This process then moves reserves between smart contracts to account for the swaps. In doing so this allows any ERC-20 token to be swapped for another and essentially means that the entire network is a liquidity pool, instead of siloing liquidity into trading pairs. Bancor also allows swapping between blockchains, currently supporting Ethereum and EOS chains. Unlike the other mentioned solutions, Bancor uses a native token to facilitate this process. 

Are liquidity pools the answer?

It’s clear that cryptocurrency needs a severe increase in liquidity, especially for the smaller assets. How can an asset experience true price discovery if liquidity is non-existent? The lack of liquidity could be stunting the growth of this sector and preventing smaller cryptos from finding their true value.

Liquidity pools are one part of the Decentralized Finance (DeFi) movement, and they seem to have real potential. Generally, these pools are able to facilitate the swap of a huge number of assets to any other supported asset, which then triggers an automated response to rejig the reserves to ensure risk is mitigated and liquidity prevails. 

As with the rest of DeFi, liquidity pools appear to be highly promising but they still have a long way to go. It’s certainly possible that they will be able to aid the growth of the cryptocurrency space, especially since the liquidity is being provided using the technology we are all here supporting. 

Therefore, it’s likely that we will experience further growth and adoption of liquidity pools in the future because they can provide a novel solution for investors and also allow another income source for liquidity providers. 

It will be interesting to watch DeFi projects to see how they can contribute to the growth and proliferation of liquidity pools. One such project to watch is ProDefi, who are aiming to bridge decentralized and centralized financial systems to create a desirable hybrid between the two worlds that uses the best from both sides. 

With ProDefi lenders can stake their funds into liquidity pools and borrowers can take out loans against those funds after a simple KYC process. This process is entirely decentralized, but to add another layer of trust ProDeFi can get back the funds through traditional judicial processes and dispute resolutions methods if a borrower default occurs, which adds a centralized element to the process to add an additional layer of protection.

Alex Aves
The Daily Chain

*Disclaimer – ProDefi are our Media Partners and therefore this content is sponsored by them. The fees paid by this project are used to pay for The Daily Chain salaries, dev work, hosting services, travel expenses etc.. that are required to make this company a success and continue to provide the community with great content on a daily basis.

Alex Aves
Alex is a crypto enthusiast that has been enthralled with the crypto space for over two years now. He currently works in the marketing team for Liquid, one of the leading crpytocurrency exchanges.

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