What is a Liquidity Pool?
In real life when groups of people “pool” their funds they’re combining their money for a common purpose. By combining funds these groups of people are able to access various opportunities they’d be unable to as individuals.
When crypto users deposit assets into a liquidity pool they’re also combining their assets for a common purpose. While different types of liquidity pools vary greatly in their purposes and levels of risk, all liquidity pools generally enable crypto users called liquidity providers to access opportunities they’d otherwise be unable to as individuals.
A liquidity pool can be broadly defined as a collection of crypto assets locked within a common smart contract. Liquidity pools are most commonly used by decentralized exchanges to enable trustless trading, decentralized money markets to enable trustless lending and borrowing, and decentralized yield aggregators to enable trustless asset management. Since blockchains are both accessible and permissionless, once a liquidity pool has been created on a DeFi application anyone is able to deposit assets into it.
When users deposit assets into liquidity pools they receive LP tokens (liquidity provider tokens) to represent their contributions. LP tokens are essentially claim tickets that can be redeemed by the holders at any time for the share of the liquidity pool that they represent. The redeemability of LP tokens gives them value, therefore LP tokens are often traded or used as collateral to borrow other assets on various DeFi protocols. This composability enables unique use cases for various types of LP tokens.
What is Liquidity Mining?
As a whole, liquidity pools allow crypto users to trustlessly interact with each other without the need for a centralized third party. When two parties interact with a liquidity pool they don’t need to trust each other since they’re interacting with a smart contract rather than a stranger. Since anyone can contribute to a liquidity pool, liquidity pools also allow anyone to earn a share of the revenues generated from liquidity provisioning in a process known as liquidity mining.
Liquidity Mining Incentives
Although liquidity pools theoretically remove the need for a third party when performing various DeFi activities like trading, lending, and borrowing, they still face some challenges. DeFi protocols, like all other products, are worthless without users. In order for DeFi applications to attract users, lots of liquidity is needed. Greater liquidity on decentralized exchanges allows users to trade more assets with less slippage, while greater liquidity on decentralized money markets helps stabilize rates and guarantee consistent liquidity for both lenders and borrowers. DeFi technologies are still in their earliest stages and are considered highly experimental, so significant incentives are needed in order to attract large amounts of liquidity.
While liquidity providers already earn a proportional share of revenue generated from a liquidity pool (trading fees, lending interest, etc.), projects often offer liquidity mining incentives in order to attract more users and deeper liquidity. Liquidity mining incentives are typically newly issued governance tokens or utility tokens that are rewarded to the liquidity providers and/or users of a specific liquidity pool or protocol.
Liquidity mining incentives may be offered to:
- Attract users to a new DeFi protocol;
- Encourage deep liquidity for the most important pools on a DeFi protocol;
- Boost liquidity for pools with higher risk profiles;
- Incentivize greater borrowing activity;
- Bootstrap liquidity for a new liquidity pool on a DeFi protocol;
- Help offset impermanent loss incurred by liquidity providers on AMMs;
- Distribute decision making power (governance tokens) to users actively supporting a protocol.