The Ultimate Guide of DeFi Liquidity Pools (2022)

Liquidity pooling is very extensively used in DeFi. It is one of the DeFi key pillars together with open-source smart contracts plus governance tokens. This article will look at:

  • Earning on DeFi liquidity pooling.
  • Regulatory risks of the liquidity pooling.
  • Alternatives to the liquidity pooling in the DeFi.

What is liquidity pooling?

DeFi liquidity pools are pools of cryptocurrency that are designed to make it easier to trade assets on a decentralized exchange. These pools are crowdsourced, with each person’s cryptocurrency locked into the pool with smart contracts. The combination of liquidity pools and automated market makers (AMM) lets exchanges offer permissionless, automatic trading of digital assets.

Liquidity pooling is most known via the Compound and Uniswap:

  • Compound operates the money market funds. The lenders add their assets into the money market funds, the borrowers can borrow the assets, and the interest is distributed between the money market fund investors. Practically speaking – investors pool their assets and earn a return on the assets. Which is a definition of an investment scheme.
  • Uniswap operates a decentral exchange. The liquidity providers can provide liquidity into the trading pairs, for example, ETH-USDC, ETH-DAI, etc. The liquidity providers are the market makers in the traditional finance terminology. Uniswap is charging 0.3% per every trade on the platform, and most of these fees are shared between the liquidity providers. And again – investors pool their assets and earn a return on the assets, which is a definition of an investment scheme.

The money market funds are distributing the borrower’s interest payments to the investors. The decentral exchanges are distributing the trading fees to the investors (liquidity providers/market makers). Both constructs are legally speaking investment contracts.

Most of DeFi is built on liquidity-providing concepts. DeFi lending platforms are doing this; all DeFi trading platforms are doing this, all futures and derivatives platforms are doing this.

How Do They Work?

A key part of any liquidity pool is that it must incentivize crypto owners to stake their assets. The most common method of doing so is by letting liquidity providers earn crypto rewards and trading fees. The reward that each liquidity provider receives will be proportional to their overall contribution to the pool’s liquidity. This is because the rewards for providing liquidity are divided among all members of the pool.

Liquidity pools use algorithms like AMM ones to keep the tokens at fair market prices. The exact protocol varies based on the liquidity pool and the platform that created it. To better understand AMM trading, you can think of it as a peer-to-contract trade instead of being peer-to-peer. This comes from the fact that there is no traditional counterparty. Buyers don’t need sellers and vice versa, thanks to automated market makers and liquidity pools.

Earning on Liquidity Pools

The opportunities to earn on liquidity pools are fairly straightforward. The most common is to become a liquidity provider in DeFi.

Liquidity Provider in DeFi

You can choose which DeFi exchange you want to provide liquidity to or find a liquidity pool to participate in. Be sure to do your research so you can accurately judge the risk and avoid potential scams.

How does it work in SmartCredit.io?

SmartCredit.io is tokenizing the peer-to-peer loans into the Credit-Coins (ccETH, ccDAI, etc.). This transferability of the loans allows building the Personal Fixed Income Funds for the investors. Investors define their investment parameters, and Personal Investment Funds will then invest automatically in the borrower’s loan requests.

Multiple investors can fill the loan requests from one borrower at the same time – the loan is tokenized into the loan tokens, and every investor (Personal Fixed Income Fund) is receiving the loan tokens. Personal Fixed Income Funds can sell or buy loan tokens.

SmartCredit.io is using an alternative, regulatory secured approach – instead of creating one pool (like Compound and Aave) are doing this – SmartCredit.io is creating multiple pools – one for every lender. These pools can invest in the same loans, but they are always below the regulatory threshold.

All the legal/regulatory risk of asset pooling/liquidity pooling does not exist in SmartCredit.io at all.

Liquidity Mining Vs. Liquidity Pools

Liquidity mining refers to when someone becomes a liquidity provider in an incentivized pool so they can maximize their liquidity provider tokens earned. This is essentially how liquidity providers optimize their earnings within a given platform or market.

Yield Farming and Liquidity Pools

Yield farming is closely related to liquidity pools, as it refers to staking cryptocurrencies with a protocol as a way to earn tokens. Yield farmers stake tokens on multiple DeFi applications as part of this goal.

The process of yield farming takes advantage of the ability to choose the liquidity pools that have the highest token payouts and trading fees paid out to liquidity providers. This, in turn, means that yield farmers can maximize their income from those fees and token payouts. It does, however, come with a slight increase in the risk.

Why Liquidity Pools Are Important and Why We Need Them

Liquidity pools are crucial thanks to their ability to ensure that the cryptocurrency markets and exchanges have enough liquidity. Slippage becomes a serious concern when there is low liquidity, as does price volatility. By using liquidity pools, DeFi exchanges can maintain the liquidity levels necessary to keep slippage to a minimum.

The value of liquidity pools quickly became apparent in the earlier days of decentralized exchanges. The early DEXs struggled to follow a similar method as exchanges for traditional assets due to the comparatively low liquidity of cryptocurrencies. Once liquidity pools were adopted, the exchanges could overcome this and quickly expanded.

What is the regulatory issue with asset pooling?

Pooling has a regulatory side effect – from 50+ users (depending on the jurisdiction), the pool will become an investment contract, meaning the pool operator needs an investment fund manager license. The pool needs an investment fund license. 

An investment fund manager license is usually required only in one jurisdiction. However, the investment fund license is required in any jurisdiction where the investment product is offered to the clients (or advertised).

These licenses are costly; they take time to apply, they involve quite some fix-costs  – that’s why the investment funds try to have at least 5+ mUSD assets. And like said, one needs them in every jurisdiction.

What’s about an open-source?

Declaring something open source doesn’t remove these regulations – pooling retail client assets and offering return to the pool is an investment contract and a regulated activity.

Many DeFi projects counter these requirements by creating governance tokens and declaring that the community owns the product via the governance tokens. This idea works like – there is no central entity making the decision, this means there is no one whom the regulator can take into the court. It’s like the defense strategy, where one creates uncertainty for the protection. However, it’s still a defense strategy because there are regulations in place.

The regulator has multiple ways to counteract:

  • The protocol developers could be sued – writing open-source code is protected in the U.S. via the freedom of speech clauses in the constitution. But no other country has such strong freedom of speech clauses as the U.S. – and not all software developers are in the U.S.
  • The website, which offers access to the platform, is a central point of access. There will be a legal entity or a natural person behind every website. The DeFi websites could be classified as “investment advisors,” which are again regulated activity in most jurisdictions.
  • The platform users could be sued, too – via the KYC/AML laws, which are active in every country. There constitutional freedom of contract. However, from certain amounts, one needs to know who the counterparty is. Not knowing this exposes the users to the “terrorism financing” laws.

This means, if the regulator wants, then there will be several legal “hooks” available even if the source code is open-source.

Practical Use Cases of Liquidity Pools

One of the biggest use cases of liquidity pools is yield farming, which we already mentioned. But this is far from the only use case.

Governance

With all the funds in a liquidity pool in a single place, participants can more easily invest in or follow a common cause that they think is important for the protocol.

Minting

To mint synthetic assets, you need to add collateral to the relevant liquidity pool. Then, you connect it to an oracle. The result is a synthetic token that you can peg to the asset of your choice.

Smart Contract Risk Insurance

Liquidity pools power a lot of the implementations in the up-and-coming sector of insurance to protect against smart contract risk.

Tranching

This involves dividing financial products based on returns and risks. It comes from traditional finance and lets liquidity providers customize their risk and return profile.

Why are DeFi protocols using so extensively liquidity pooling?

DeFi protocols are built on Ethereum, setting quite some limitations to how developers can build the products. The fundamentalist idea in DeFi is that everything has to run on the blockchain.

For example:

  • Collateralization ratio’s in the Aave and Compound protocol are hardcoded (although in traditional finance, the collateral ratio’s are client-specific)
  • The interest rate in Aave and Compound are defined via the utilization formula (although there should be a market mechanism for setting the interest rate)
  • The market price in Unswap is defined via the “A x B = C” formula (Uniswap assumes that the resulting price-arbitrage will be done outside of the DeFi world – in the central exchanges)

These examples simplify traditional finance – either the collateralization ratios or interest rates, or market price. But not only – but there is also another reason. Setting the fundamentalist restrictions that everything has to be on the blockchain limits the possible implementations. These fundamentalist limitations have resulted in extensive liquidity pooling. There has to be liquidity either for lending or market-making. But there might be alternatives?

What are the alternatives to liquidity pooling?

It’s about asset pooling/liquidity pooling. One should not pool the assets. Or, if one pools assets, it should always be below the level from which it’s considered an investment contract.

This means:

  • Either you use pure peer-to-peer transactions or
  • You use asset pooling below the regulatory threshold

So, far there are only two projects in the DeFi world doing this:

  • Maker DAO – which is minting DAI stablecoin via the lending transactions. There is no counterparty; there is no asset pooling
  • SmartCredit.io – which is providing peer-to-peer crypto lending

The Risks of Liquidity Pools

While DeFi liquidity pools have plenty of great opportunities for investors and the continued expansion of blockchain tech, there are also some risks.

Impermanent Loss

The biggest concern with providing liquidity is impermanent loss. This refers to the fact that if you were to look at your investments in dollars instead of fiat, you may find yourself with a loss compared to HODLing. This is a risk any time you provide an AMM with liquidity, but the degree of the risk varies.

Smart Contract Risks

Another potential risk is that of smart contracts. Remember that liquidity pools don’t have middlemen, as everything is handled by smart contracts. But if the smart contract has an exploit or bug, you can lose your funds.

Changing Governing Rules

The final risk is something that is easy to overcome by carefully choosing which liquidity pools to provide tokens for. Some pools are set up so developers can change the rules that govern the pool. This opens the doors for malicious actions, like stealing or controlling the funds in the pool. To avoid or minimize this risk, carefully research your chosen pool before providing liquidity.

Conclusion

Liquidity pools let you stake your tokens into the pool, providing liquidity for decentralized exchanges. In exchange, you earn a portion of the transaction fees and potentially other token rewards.

Earn interest on crypto with SmartCredit.io.