Until recently, accessing liquidity was like an exclusive pool party in the Hamptons.

It was not for everyone: you had to know a banker or someone from Wall Street to get in. Entry requirements were strict: you could only wear white or linen. The waiting time was also very long: you had to find the right time to be greeted by the party host. Last but not least, the benefits you received were minimal: you lost interest after a few minutes of boring conversation and left the party hungry (that’s what fancy canapés do to you). 

But today, you're invited to a different party. A party organised by a group of like-minded people, just over a thousand miles further south, in Miami.

It’s a more inclusive party: you don’t need to know the host, just a friend of a friend will let you in. The entry requirements are much more flexible: just come as you are and bring what you can. There is no waiting time: this is everyone’s party. More importantly, here you can really enjoy yourself: people have their own personalities, they exchange interesting ideas, and food is out of this world.

This is what it’s like to get in a liquidity pool in DeFi.

Offering high returns and greater opportunities for credit, it’s no surprise that decentralised global liquidity pools have exploded in popularity over the last few years.

To put things in perspective, at the time of this article, the total value locked in DeFi liquidity pools is $108.48B.

So if you are a new retail crypto investor or a small business looking for new and innovative ways of gaining funding, you want to keep reading.

Liquidity pool in plain English

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

In traditional finance (Centralised Finance or CeFi), liquidity is provided by a central organisation, such as a bank or a stock exchange. 

Banks have lengthy and paper-intensive processes, cumbersome and costly infrastructures, and minimise their risk-exposure by only backing organisations that adhere to strict criteria. This leaves companies with less formalised governance processes, no publicly available information, and not enough assets to be used as collateral out of the party.

A traditional stock exchange is another place where liquidity can be accessed. But they come with their own limitations. With buyers looking for the lowest prices and sellers trying to get as much as they can, the two parties might not agree on a price.

Sometimes, there is not enough liquidity in the exchange to execute a buyer’s order. That’s when delays arise, as traders need to wait for another buyer or seller to place an order.

That’s the traditional order book model, the limitations of which Market Makers (MM) such as Coinbase or Gemini have set out to overcome.

MMs are centralised exchanges always willing to buy or sell assets at a specific price, thereby offering a place for buyers and sellers to meet and trade. 

Often using their own assets, MMs make sure there is always liquidity in their exchange. That’s why users can trade 24/7/365 with no delays (as opposed to traditional stock markets such as Wall Street, which opens at 9.30 and closes at 4pm EST).

Whilst MMs are an improvement from traditional stock exchanges, their transactions are relatively slow (they operate as a centralised exchange based on the order book model) and costly (due to the considerable fees they charge for facilitating traders’ transactions).

With DeFi, and the introduction of Automatic Market Makers (AMM), a new and better way to access liquidity has come about. AMMs are smart contracts that regulate trading. Being decentralised, they allow buyers and sellers to trade directly with each other, without needing to be matched by a central market maker through the order book model.

Call it peer-to-peer trading — or peer-to-contract trading, since users trade directly against a smart contract.

How Liquidity Pools work

In DeFi, traders provide liquidity to Decentralised Exchanges (DEXs). They operate like traditional exchanges, but are not affected by their weaknesses, such as lengthy transactions, high gas fees and slippage.

When traders lock their assets in a smart contract, a liquidity pool gets created. We can define a “pool” as the sum of at least two tokens locked in a smart contract.

And why would traders do that? Because they’re rewarded for it.

Liquidity protocols that act as AMMs are Uniswap, Bancor, or Balancer. They offer rewards to liquidity providers as shares of the transaction fees or additional cryptocurrency tokens.

Oftentimes, it’s only possible to get hold of a token when it launches. And there are also users who take part in liquidity pools because they believe in a decentralised project and want to benefit from the governance rights some tokens offer.

Want to see real-world examples? Here are some for you.

For the purpose of this article, it is important to note that liquidity providers can earn high yields, not just through native tokens and transaction fees, but also by lending cryptocurrencies — especially stablecoins.

These rates surpass by far those paid by traditional banking services. It is common to find pools offering 110% — or even as high as 90,000% APR.

The rewards are proportional to the risks, of course. Impermanent loss and a total loss of funds through smart contract failures or malicious rug pulls can, and do, happen.

As DeFi reaches mass adoption, these risks will reduce (and lucrative rewards with it), but not the benefits offered by liquidity pools.

The most inclusive liquidity pool party is getting started

As of today, cryptocurrencies are the primary source of liquidity in DeFi.

But what about SMEs and individuals who today can’t get access to funding through the existing channels? 

The International Finance Corporation (IFC) estimates that 65 million firms, or 40% of formal micro, small and medium enterprises (MSMEs) in developing countries, have an unmet financing need of $5.2 trillion every year.

These businesses are cash-strapped and are looking for ways to get funding quicker and on their own terms, without relying on central institutions. They don’t have crypto wallets and are not familiar with the complexity of the new ecosystem.

The only way for them to access new funding is to be onboarded to DeFi as real world asset originators, so they can use their invoices, inventory, letters of credit, royalties, etc. as collateral.

Connecting real world assets with DeFi liquidity pools will bring about a real financial revolution. 

Millions of businesses across the world are crying out for new funding avenues. Let’s get them through the door.

That’s when the best pool party will get started.