Liquidity Pools: A User Guide and Outline of Primary Features and Components of Differing Models.

While the concept of a Liquidity Pool has been around since 2017, use and demand has exploded and they have been popularized as a lucrative feature on a number of Decentralised Exchanges (DEXes) such as Uniswap and Curve Finance. At its most basic form, Liquidity Pools are a pool of tokens used as liquidity and locked into a smart contract. They often benefit participants by being “open to all”, offering incentives like governance/pseudo-equity tokens, lower gas fee’s on the platform and receiving and Annual Percentage Yield (APY) on tokens lended. DEXes are benefited with capital to their platform, increasing user base and prevent large swings in token pricing. When effective they have proven to be a lucrative investment and offer high rewards. However they can also contain drawbacks and pitfalls: only certain investors are favored, nefarious practices like rug pulls have occurred and pricing fluctuations can result in financial loss. Highlighting the ease of using these systems is a step-by-step guide for using Uniswaps Liquidity Pool. Prior to designing or choosing a Liquidity Pools it is important to understand the varying models and how each creates risk, incentives, obtains liquidity and are structured overall. Three primary models are detailed: Automated Market Makers, Lending Pools and Options Liquidity.

Benefits

Participants providing Liquidity are rewarded with benefits such as:

• Being “Open to All”. No KYC is required, anyone holding the requested tokens for liquidity can participate irrelevant of geographical location or jurisdiction restrictions;
• Opportunity to acquire governance/pseudo-equity tokens;
• Can offer lower gas fee’s on transactions; and
• A way to obtain a APY on held cryptocurrency.

DEXes offering this service are benefited by:

• Providing liquidity to the platform and obtaining required tokens to facilitate trades;
• A way to offer incentives to participants and attract users to use their services; and;
• Prevent large swings in token pricing.

Risks

• While “open to all”, the greater benefits are provided to those who can offer high liquidity. Unless large sums are deposited the incentive may not be worth it. In the majority of cases the rich are rewarded and mum and dad investors are at greatest risk.
• Users may gain money, however they are still a risk and you may actually lose money; trading activity can influence the coins provided and you can pull out a different amount then provided. Even though the tokens are “locked”, the price isn’t.
• How the Liquidity Pool is set up can be complex. Not all platforms provide the same returns or incentives. As a DeFi, the users are what keep DEXes in check not an overarching governing body. How they are set up is outlined further down.
• DEXes may be at risk of large liquidity being suddenly pulled. Many contracts allow participants to pull at any time. Once incentives are obtained there may be little interest to keep cryptocurrency in liquidity. If large assets are removed this can affect the price.
• Malicious practices have been used by DEXes in the past. For example Compounder Finance built into their smart contract an ability to withdraw all funds and engaged in a “rug pull” effectively stealing the assets of those who provided liquidity. In these circumstances there is little to no recourse to recover funds.

Example of Liquidity Pool — Uniswap

Uniswap is one of the most popular exchanges used for Liquidity Pools. To invest, you require an 50:50 pair of Ethereum and another token. A feature of Uniswap is that you can join an existing pool or create a new pool if a pair doesn’t exist.

To reward participants, each time a trade occurs using your pool the trader submits a 0.3% transaction fee. This fee is awarded to pool investors. If you have provided 20% of liquidity in a pool, you will receive 20% of every 0.3% transaction using this pool. The more liquidity and times the token pair is traded, the higher the return.

Joining an existing pool is straightforward and can be accomplished using the following steps:

1.) Log onto the Uniswap Exchange: https://uniswap.exchange and select Pool.

2.) Connect your wallet such as Metamask to the Exchange.

3.) Choose “Add Liquidity”

4.) The first input required is Ethereum. You need to match an equal monetary value of Ethereum to the Token you want to add as liquidity. When units are added you will see your percentage Share of the Pool.

5.) Once the amounts are entered, you can now “Approve Uni”. This will allow Uniswap to connect to your wallet, which is how it connects you to the pool. Please note that this will incur a Gas Fee. Once approved, you can now supply the Liquidity, again this will incur a gas fee. While you can add low amounts to these Liquidity Pools, please note that the gas prices incurred may be higher than the liquidity provided. As such it is more beneficial to add a higher amount of liquidity if you are able to afford it.

6.) Once you have Supplied a Pool, you will be able to see your balances within the pool as well as your share of the total. Your pair will now appear under the Pool section when your wallet is connected.

7.) You can exit the pool anytime by selecting the pool, confirming how much liquidity you want to pull out and selecting Remove, then confirm the transaction (please note another gas fee). This will now move your tokens inclusive of any fees obtained to your connected wallet.

Models of Liquidity Pools: Design and Core Components

From the development perspective, numerous components need to be established by DEXes to attract and maintain investors (and liquidity), cover the cost of incentives, provide benefits and reduce slippage. There are three primary designs used in Liquidity Pools: Automated Market Maker (AMM), Lending Pools and Option Liquidity. Each type applies a framework providing parameters that influence the application of leading market rates and performance, amounts of liquidity required, how the cost of incentives are covered, potential adjustments to assets on return and if contracts are locked in or can be pulled out at any time.

Automated Market Maker

The most common method is using an Automated Market Maker (AMM), which uses mathematical formulas in the smart contract to price assets. Within the AMM framework various models have been established such as:

(x*y = k) or XYZ Model

Gains are predominately acquired through transaction fee’s which is distributed to pool participants pro-rata at the point of trade with constant product pricing functions (x*y=k). The primary risk of this model is Impairment Loss (IL) where the price of deposited tokens can change from when they were deposited which can result in a diminished return.
Examples of DEXes using this model are Uniswap and SushiSwap.

(x+y=k)

To limit Impairment Loss, Curve a DEX uses a constant sum function (x + y = k). Stablecoins and BTC are used rather than Ethereum, This method has shown to be beneficial for large trades, targeting equally-priced assets. CRV tokens are distributed daily to pools, however while initially large gains were made, the APY is approximately 5–30% with a downward trend. There is less opportunity for IL using this model, however as APY has settled the returns are also lower.

Lending Pools

Incorporate the traditional concept of lending transferred where assets (in the case of Cryptocurrency tokens) are transferred to a lending pool which at a later period can be redeemed for an equal or increased token amount. To initiate this loan, borrowing requires collateral which are locked for the loan duration. The incentive for lending is acquiring interest applied to the loan amount. This approach is low risk, however the returns are generally not as high as other Liquidity Pool formats. There is also a risk of having collateral seized if repayment is not made. This approach is used in the Cryptocurrency sphere by Aave and Compound. This is a more straightforward model, with numerous papers outlining set-up which may make it an attractive option for developers.

Option Liquidity

Like Lending Pools, Options / Collateral Pools apply an approach taken from traditional finance pools. Contracts are used and allow the holder to buy and sell tokens at a set price. As derivatives, they obtain their price from an underlying asset. Call options allow an investor to buy, while put options to sell. An expiration date is set, and investors must buy at the strike price. Cryptocurrencies are volatile, if the token value improves profit can be made, but loss if a token dips. To mitigate loss, the amount is capped. Profit is calculated by subtracting the strike price and premium from the current asset price.

DEXes such as Hegic and FinNexus have applied this concept within liquidity pools. Unlike Lending Pools or AMM models, currently only one token is required but currently limited to WBTC or ETH. In the case of Hegic, $rHegic Tokens are earned as a percentage of the liquidity provided to the pool and act as an IOU and cashed out when milestones are reached (or cashed out earlier at a much lower rate). Rewards are higher, however so is the risk.

Each of these types of Liquidity Pools contain Core Components outlined in the below table:

Conclusion

Liquidity Pools are a new and attractive feature of DEXes. They can be very lucrative, but investors are wise to assess the benefits and risks prior to participation. As no KYC is required and only a cryptocurrency wallet with the required tokens is needed it is very easy for investors to jump in. This was demonstrated with the Uniwap step-by-step user guide. Various models exist for Liquidity Pools which has major impact of their design, and influence components such as how liquidity is pooled, types of incentives, incentives funded, risks and placing guidelines on how they are developed and applied. Traditional finance models have been migrated to the DeFi Cryptocurrency sphere with Lending Pools and Options Liquidity, as well as new models specific to Cryptocurrency with Automated Market Makers. DEXes using Automated Market Makers are are developing new algorithms to mitigate risks of Impairment Loss with methodology constantly expanding. Understanding how these models operate influences how they are developed and may assist potential participants prior to investing.