There has been lots of buzz around the word “Liquidity Pools” in the DeFi environment as they drive trading and incentivize users. But what exactly are Liquidity Pools?
Liquidity pools lock tokens inside a smart contract, a concept first introduced by a project named Bancor. As you can gauge by the name of liquidity pools, they work as market makers in decentralized trading finance. In a centralized setting, the buyer wishes to buy any asset at a lower price and the seller wants to sell it at a higher price. The challenge is to match these orders. Low liquidity will cause lots of order cancellations and customer dissatisfaction. This is where the liquidity pool plays an important role.
How does this all play out in decentralized finance?
As it is already mentioned that the centralized exchange is at a disadvantage of order cancellations due to the price fluctuations. The order book model relies heavily on individual market makers to create the market for certain assets. The dependency on the user based market makers can potentially make the exchange illiquid.
To eradicate this dependency in the DeFi environment and to control the price fluctuations, a liquidity pool is created to accommodate two tokens having different holding ratios. A 50/50 liquidity pool incentivizes the liquidity provider to supply an equal amount of both tokens. This helps to halt the price divergence from the global marketplace. To keep this balance constant, an algorithm is employed that ensures to provide liquidity even for larger trades. This algorithm increases the price of the underlying asset once the demand increases, mimicking traditional finance.
In the case of arbitrage between the set price and the market price, LP can lose capital. To minimize the loss, a deterministic pricing algorithm is employed to help facilitate the price adjustment, a mechanism otherwise known as the Automated market maker (AMM) process.
Antlia’s StakeFlow and how it’s different?
Antlia StakeFlow forms such liquidity pools with its synthetic tokens such as ANAETH/ETH, ANADOT/ETH, ANAATOM/ETH, and ANABNB/ETH in different ratios. These ratios will dictate the price depending on supply and demand. For example, the unequal ratio ANAETH/ETH pool with more supply of ANAETH and less supply of ETH can cause the price increment for ETH and reduction for ANAETH. This price impact often known as slippage is far less in large trade pools.
Stakeflow’s deterministic pricing algorithm with its AI capabilities based on Metric of ROI, risk score, and price prediction of all pools and vaults will allow the pool to keep the price constant to what it had been initiated with.
Benefits of liquidity pools:
- High Volume Trades
Liquidity pool ensure higher volume trades due to the warranted liquidity as long as the investments are constant in the correct ration
- Passive Market Making
The LP provides the tokens in the form of funds or investments and reaps benefits from it. The price is handled by the smart contract algorithm keeping the price fluctuations at a bare minimum.
- Less Limitation
To become a LP in DeFi, no exclusive listing or KYC is needed like in centralized exchange. The low hassle encourages more investors to provide liquidity thus allowing it to increase
- Low Gas Fees
Minimalist smart contract design allows users to invest more with lower fees. This helps to keep volatility at bay.
- Higher Returns
Liquidity pool allows higher returns through:
1. The asset prices on delivery and withdrawal.
2. The volume of the liquidity pool.
3. Trading size.
Liquidity Pool Risks
- Impermanent Loss:
Liquidity Pool Providers face a major risk of impermanent loss which is sometimes inevitable. If you are an LP for a deposited asset whose price has fluctuated a bit, you will be prone to impermanent loss. To avoid this problem, the pools shall be kept at a smaller price range; stable coins and wrapped tokens are often in a contained price range which makes them a safer option to invest. The reason why LP still provides liquidity despite the higher risk of potential losses is that they gain trading fees making them profitable, though margin can be low.
- Smart Contract Bugs:
Liquidity Pools are locked inside smart contracts; a smaller bug can propagate through the whole system disrupting the assets ratios
- Liquidity Pool Hacks:
Draining the liquidity pool by trading tokens in the loop causing price fluctuations is a popular hacking method that major DeFi platforms have suffered. Such an attack is also called a Flash attack. There should be several security measures to mitigate these risks.
Investing in liquidity pools can be profitable, but it comes with bigger risks. It is important to choose the best platform with a constant price liquidity pool to lower the chance of loss. Moreover, most LP providers might withdraw different ratios of assets causing the imbalance. Investing in the bigger liquidity pool with a lesser chance of impermanent loss can return higher gains.