Liquidity pools explained

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SCORECHAIN

Date: November 25th 2021

Published on: Global News

Tags:

crypto AML, Crypto Compliance, Cryptocurrency, Cryptoregulation, DeFi, DEX, liquidity pool, Risk assessment, RiskAML, rug pull,

You might have heard about liquidity pools (LP) before but are not sure what it is about? Look no further, this article will explain all you need to know on the subject.

Liquidity pools is a term that we can often come across in decentralized finance (DeFi). Recently, there has been a boom in DeFi usage. For example, on November 25,  2021, the amount locked in DeFi protocols was amounting to around $107 billion against 22 billion for the same period last year (DeFi Pulse). Liquidity pools are the technology behind DeFi applications. Consequently, they are increasingly important with a growing number of people taking interest in them. 

What exactly are liquidity pools?

In short, liquidity pools are pools that hold a combination of 2 tokens. These tokens are locked in a smart contract. Liquidity pools are the underlying technology used in DeFi and let users conduct trades. For example, lending/borrowing platforms or decentralized exchanges (DEXs) use liquidity pools.

Order book on Binance cryptocurrency exchange
Order book on Binance cryptocurrency exchange

Many trades taking place in DeFi also take place on CEXs (often for P2P transactions). However, liquidity pools are not used by centralized exchanges (CEXs); they will rather use order books, that are also used for stock exchanges.

In this model, the price adjusts according to demand and supply, and the trade is executed when the buyer and seller reach an agreement on the price. Here, liquidity is provided by market makers; they always agree to buy or sell a certain token.

But, the order book model isn’t very suitable for DeFi and would have been inefficient. For DeFi, the model is different because users don’t interact with each other but rather with a smart contract. Liquidity pools thus provide liquidity and allow trades to take place on DeFi protocols. But as DeFi is evolving, some DEXs are starting to use order books as well with price limit features.

To sum up, liquidity pools let users exchange one kind of token for another one in exchange for a small fee.

How do liquidity pools work?

A liquidity pool always holds two tokens with a 50:50 ratio. For each coin combination held in a pool, a new market is created, such as ETH/USDT or USDT/USDC for example.

To keep this 50:50 ratio, the price of token A will increase when someone buys token B. Same goes for the other way around; the price of token B will decrease if there is a larger quantity of token A in the pool. This is how liquidity pools remain balanced. 

The price of tokens held in a liquidity pool tends to be more stable in larger liquidity pools because the price of tokens is less affected by large buying. In essence, the bigger a liquidity pool is, the lesser price slippage there is.

In DeFi, since the user doesn’t interact with a counterparty, the trade takes place thanks to automated market makers (AMM) and liquidity pools must maintain this 50:50 ratio.

How are liquidity pools funded?

People who are funding liquidity pools are liquidity providers. They will earn the fees paid by users to complete trades with the liquidity pool. The fees will be proportional to the share of tokens supplied by the liquidity provider.

Adding liquidity to SushiSwap’s ETH/USDC pool

Are liquidity pools risky?

Same as for any financial product, DeFi has some risks. Users should be careful when using DeFi products such as liquidity pools; it is recommended to carefully assess whether the DeFi project is trustworthy or not. Here we’ll take a look at the most common risks you can encounter with liquidity pools.

Rug pull scams

A rug pull is a kind of exit scam. The scammer creates a scam token, promotes it to the community, and creates liquidity pools with it. Once a significant number of users have swapped their coins for the scam token, the scammer withdraws everything from the liquidity pool, driving the scam token price to zero and leaving investors with worthless tokens.

Users can pay attention to several factors to assess a token’s credibility. Users can usually trust a token’s project if the team looks credible, if the project has a white paper and if the contract has been audited. However, users should be wary of projects offering unrealistic returns and with unlocked liquidity.

To give an example, we can look at the Squid Game Token, a cryptocurrency based on the Netflix series. The token’s price grew rapidly thanks to promising returns and the increasing popularity of Netflix’s show until the end of October. On November 1, Squid Game Token’s operators pulled all the money invested out of the project (more than $3 million). The liquidity pool disappeared from exchanges and the price of the token collapsed to nearly zero.

Impermanent loss

When investors are putting liquidity in a pool, they face a risk of impermanent loss. An impermanent loss is a temporary loss of funds that happens when the 50:50 ratio of a liquidity pool is uneven due to price fluctuations. To illustrate, let’s first take two tokens as follows:

Moment(1): token A = 1$, token B = 100$

In this situation, the liquidity pool contains 100 units of token A (for 1$ each) and 1 unit of token B (for 100$ each).

Then, if the price of token B increases by 100%, it would be worth 200$ with the following situation:

Moment(2): Token A=1$, token B=200$

However, in this situation, the liquidity pool contains 100 units of token 1 and only 50 units of token B (now worth $200 each).

Because there is a lesser quantity of token B in the pool, there is an impermanent loss. If the liquidity provider decides to withdraw the funds from the pool at this moment, the loss becomes permanent.

How to avoid DeFi-related risks with Scorechain?

With Scorechain Ethereum Analytics platform, users can get comprehensive information on AML risks stemming from DeFi activity.

The solution supports DEXs and assigns a medium-low risk scoring. Users can easily customize risk scoring for the DEX type and for specific named entities to suit their risk appetite. Moreover, the risk indicator DEX notifies users if an address, an entity, or a transaction is related to DEXs.

Scorechain Ethereum Analytics platform also spots DEX trades and notifies users. This is a very useful feature as token swaps can sometimes hide money laundering attempts. The platform is able to follow assets even after being swapped. (Read more: Scorechain’s new feature can trace Kucoin hacker’s funds transfer via DEX)

Moreover, Scorechain immediately integrates and red-flags addresses related to scams such as rug pulls or fake tokens, and hacks. Compliance officers have thus all the needed tools to implement a risk-based approach to crypto transaction monitoring and can comply with all relevant legal requirements.

Would you like to get a demo of Scorechain’s tools and see how it can suit your business’ compliance needs? Don’t hesitate to reach out.

About Scorechain

Scorechain is a Risk-AML software provider for cryptocurrencies and digital assets. As a leader in crypto compliance, the Luxembourgish company has helped more than 200 customers in 40 countries since 2015, ranging from cryptocurrency businesses to financial institutions with crypto trading, custody branch, digital assets, customers onboarding, audit and law firms, and some LEAs.

Scorechain solution supports Bitcoin analytics with Lightning Network detection, Ethereum analytics with all ERC20 tokens and stablecoins, Litecoin, Bitcoin Cash, Dash, XRP Ledger, Tezos, and Tron with TRC10 and TRC20 tokens. The software can de-anonymize the Blockchain data and connect with sanction lists to provide risk scoring on digital assets, transactions, addresses, and entities. The risk assessment methodology applied by Scorechain has been verified and can be fully customizable to fit all jurisdictions. 300+ risk-AML scenarios are provided to its customers with a wide range of risk indicators so businesses under the scope of the crypto regulation can report suspicious activity to authorities with enhanced due diligence.