When we talked about Centralized and Decentralized Exchange, the term liquidity appeared.
“Liquidity in crypto can be provided by crypto assets backed by traditional assets, aka by bridging crypto and fiat markets. Higher liquidity would cause faster transactions, more stable prices and therefore more market participants. This would boost the general public adoption of blockchain technology and crypto instruments and lead to “maturity” of the industry. While there are discussions around Crypto VS. Fiat worlds, crypto is more of an extension, the next evolution step for the financial market as a whole.”
To explore the concept, let’s dive into the aspect of Liquidity Pool
In a pill: Liquidity Pools enable users to buy and sell crypto on decentralized exchanges and other DeFi platforms without the need for centralized market makers.
As we already know, Decentralized Finance (DeFi) aims at the decentralization of conventional financial services such as lending, borrowing, and exchanges. Its growth points towards the decentralization of liquidity by leveraging global liquidity pools.
“A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (DEX). Instead of traditional markets of buyers and sellers, many decentralized finance (DeFi) platforms use automated market makers (AMMs), which allow digital assets to be traded in an automatic and permissionless manner though the use of Liquidity Pools.”
In depth, what is a Liquidity Pool?
In a pill: “A DeFi liquidity pool is a smart contract that locks tokens to ensure liquidity for those tokens on a decentralized exchange. Users who provide tokens to the smart contract are called liquidity providers.”
Crypto liquidity pools play an essential role in the Decentralized Finance (DeFi) ecosystem — when it comes to Decentralized Exchanges (DEXs).
It’s basically an ensemble of funds locked within a smart contract. Liquidity pools facilitate different types of transactions such as decentralized lending and trading, along with many other functions.
Some users referred to as “liquidity providers” could add the equivalent value of two tokens in a specific pool for creating a market. Liquidity providers could earn the trading fees from all transactions carried out in their pool.
The trading fees depend directly on their share in the total liquidity.
Before automated market makers (AMMs) came into play, crypto market liquidity was a challenge for DEXs on Ethereum: at that time, DEXs were a new technology with a complicated interface and the number of buyers and sellers was small, making it difficult to find enough people willing to trade on a regular basis. AMMs fixed this problem of limited liquidity by creating liquidity pools and offering liquidity providers the incentive to supply these pools with assets, all without the need for third-party middlemen.
The more assets and liquidity there are in the pool, the easier trading becomes on decentralized exchanges.
How does a Liquidity Pool work?
In a pill: “The simplest version of a DeFi liquidity pool holds two tokens in a smart contract to form a trading pair.”
An operational crypto Liquidity Pool must be designed in a way that encourages crypto-liquidity providers to deposit their assets into a pool. That is why most liquidity providers earn trading fees and crypto rewards from the exchanges where they pool tokens. When a user supplies a pool with liquidity, the provider is often rewarded with Liquidity Provider (LP) tokens.
LP tokens can be valuable assets in their own right and can be used throughout the DeFi ecosystem in various capacities. Usually, a crypto liquidity provider receives LP tokens in proportion to the amount of liquidity supplied to the pool.
When a pool facilitates a trade, a fractional fee is proportionally distributed amongst the LP token holders. For the liquidity providers to get back the liquidity they contributed (in addition to accrued fees from their portion), their LP tokens must be destroyed.
Also, when users want to withdraw their stake in the liquidity pool, they “burn” their pool tokens and can withdraw their stake.
Liquidity pools maintain fair market values for the tokens they hold thanks to AMM algorithms, which keeps the token price the same to one another in a specific pool.
Use of Liquidity Pool
Many of the best liquidity pools gained popularity in 2020. As of now, Uniswap is the most popular decentralized exchange credited for operations of some of the biggest Liquidity Pools.
With so many promising applications of the Liquidity Pool concept, it is reasonable to wonder about their other promising uses:
The first use case focuses on liquidity mining or yield farming. Users could add their funds in pools on these specific platforms, which are used later to generate yield.
Yield farming is the practice of staking or locking up cryptocurrencies within a blockchain protocol to generate tokenized rewards. The idea of yield farming is to stake or lock up tokens in various DeFi applications in order to generate tokenized rewards that help maximize earnings. This allows crypto exchange liquidity providers to collect high returns for slightly higher risks; it happens because their funds are distributed to trading pairs and incentivized pools with the highest trading fee and LP token payouts across multiple platforms.
This type of liquidity investing can automatically put a user’s funds into the highest yielding assets pairs.
The second use focuses on the distribution of new tokens to the right people in different crypto projects. The algorithmic distribution of tokens to users who have placed their tokens in the Liquidity Pool provides better efficiency: the newly minted tokens are distributed according to the share of each user in the liquidity pool.
It is important to remember that such tokens could also come from other Liquidity Pools, also referred to as pool tokens. For instance, users lending funds or offering liquidity would get the tokens representing their share and then deposit the tokens in another pool to earn viable returns.
Third use, Liquidity Pools could also serve as helpful instruments in governance. This is a structure where a participant or user of a system agrees to use the system. Almost every social structure has some sort of governance. You will also find governance in places where you least expect. After all, governance helps us to live a better life and follow the rules for everyone’s benefit.
Therefore, it is possible to discover a potentially higher threshold of token votes required for establishing a formal proposal for governance. However, pooling funds together as an alternative could help participants rally behind a common cause perceived as significant.
Other applications of Liquidity Pools in DeFi ecosystem include safeguards against smart contract risks and tranching. Many DeFi implementations leverage the Liquidity Pool concept to protect against smart contract risks.
Liquidity Pools also support tranching or division of financial products according to risks and returns associated with them: the products could help liquidity providers with a selection of customized risk and return profiles.
The risks associated with Liquidity Pool
In a pill: “The algorithm that determines the price of an asset may fail, slippage due to large orders, smart contract failure and more.”
The price of assets in a Liquidity Pool is set by a pricing algorithm that continually adjusts based on the pool’s trading activity. If an asset’s price varies from the global market price, arbitrage traders that take advantage of price differences across platforms will move to profit from the variance.
In the event of price fluctuations, liquidity providers can incur a loss in the value of their deposits, known as impermanent loss. However, once a provider withdraws their deposit, the loss becomes permanent. Depending on the size of the fluctuation and the length of time the liquidity provider has staked their deposit, it may be possible to offset some or all of this loss with transaction fee rewards.
Pricing algorithms in liquidity pooling could also lead to concerns of slippage for smaller pools. DeFi users face other risks, such as smart contract failure, if the underlying code isn’t audited or fully secure. That is why it is vital to understand all the risks before depositing any funds.
Benefits of DeFi Liquidity Pools
The most obvious benefit of Liquidity Pools is that they ensure a near-continuous supply of liquidity for traders wanting to use decentralized exchanges. They also offer the opportunity to profit from cryptocurrency holdings by becoming a liquidity provider and earning transaction fees.
Furthermore, many projects and protocols will offer additional incentives to liquidity providers to ensure that their token pools remain large, reducing the risk of slippage and creating a better trading experience.
How to join a Liquidity Pool?
The procedure varies from platform to platform, according to different protocols.
In general, one would need to set up an account on the platform of choice and then connect a digital wallet from the homepage. After that, tokens can be deposited into the relevant Liquidity Pool.
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