Incentivized liquidity pools (with & without leverage)

Incentivized liquidity pools (with & without leverage)

A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and many more functions we’ll explore later. Liquidity pools are the backbone of many decentralized exchanges (DEX), such as Uniswap. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity. As anyone can be a liquidity provider, AMMs have made market making more accessible.

A liquidity pool can be thought of as a pot of cryptocurrency assets locked within a smart contract. The funds can then be used for exchanges, loans and for many other applications.

By far the most popular use case for liquidity pools is on decentralised exchanges, which have become the backbone of the DeFi ecosystem. Decentralised exchanges allow users to swap cryptocurrency assets via smart contracts. They are able to achieve this through the application of an automated market maker (AMM).

A leveraged AMM LP position is therefore a bet on trading volume against price volatility, — since if the price diverges too far from the initial value, the impermanent loss will outweigh trading fees, triggering a liquidation event that may consume the principal in order to repay the creditors.

Aside from that speculative component, leveraged LP is attractive in certain market conditions or for certain assets — for instance, for stablecoin vs. stablecoin pairs, since, unless one of the pegs is broken, the volatility is known to be low.

Leveraged liquidity provision can be seen as one of the instruments facilitating liquid automated markets and extending the range of possible trading strategies.