Defining decentralized finance (DeFi) as a digital revolution implemented through decentralized networks is appropriate. A transparent system that replaces the old, inefficient financial system eliminates the need for third-party custodians or intermediaries.
Various DeFi initiatives have appeared in the cryptosphere over the past two years, some of which feature unique concepts.
Liquidity Pools are known to be one of the pillars that fuel the abundance of the DeFi world and are crucial to its success.
What are Liquidity Pools?
Liquidity Pools are thus defined as follows:
The Liquidity Pool is a repository of crypto funds — mainly in pairs — that runs on smart contracts, which allow users to carry out decentralized, permissionless borrowing, lending, and trading activities and get cryptocurrency rewards as a result.
The importance of Liquidity Pools
The order book of centralized crypto exchanges resembles the order book of traditional stock exchanges, where orders are placed by buyers and sellers. A buyer tries to get the lowest possible price for an asset, whereas a seller tries to get the highest possible price for selling it. For the transaction to occur, both buyer and seller must agree on the price.
How can this be achieved if neither party agrees on a price? Is there a possibility the order will not be executed because there is not enough liquidity? That is why Market Makers exist. Through market makers, traders can trade without waiting for another buyer or seller to appear, as they provide liquidity by offering to buy or sell a particular asset.
Transactions in Decentralized Finance (DeFi) may be relatively expensive and slow if they depend too heavily on external market makers. The solution is Liquidity Pools.
Liquidity Pools allow users to pool their assets to provide liquidity for traders willing to swap currencies. Through Liquidity Pools, DeFi provides much-needed liquidity, speed, and convenience to its ecosystem.
How do Liquidity Pools work?
AMMs are at the core of the Liquidity Pool concept. The possibility of trading on token pairs here is significantly greater than on order book exchanges, where these token pairs would be illiquid.
In a nutshell, what is an Automated Market Maker (AMM)? It is clear from the following that manual market makers and order books are insufficient to meet the needs of decentralized trading protocols. AMMs rely on mathematical formulas to price assets as part of the decentralized exchange (DEX) protocol. The asset price is determined by using an algorithm, not an order book as on a traditional exchange.
The AMM can be viewed as a robot that is always willing to offer you a price between two assets. There are some formulas which are simple to use, such as Uniswap’s one, while others such as Curve and Balancer utilize more complicated formulas.
There are Liquidity Pools for certain pairs of assets on decentralized exchanges (e.g. DAI/ETH). When the Liquidity Pool is created, the initial prices and quantities of both assets are determined by the liquidity provider equally. Liquidity providers willing to participate in the pool follow a similar policy of an equal supply of both assets.
Those providing liquidity to the pool are rewarded in proportion to the amount of liquidity they supply. A transaction fee is paid to each Liquidity Provider when the trade is facilitated.
Liquidity Pools can be used in various ways through different smart contracts. For instance, by using Constant Market Maker, you can ensure a continuous amount of liquidity. Liquidity Pools determine the price of assets based on token ratios.
Liquidity providers are sometimes rewarded with extra tokens by some smart contracts. A method of doing so is known as liquidity mining.
As a result, the Liquidity Pool replaces Centralized Order Books with an alternative method that permits Decentralized exchanges to directly access liquidity without depending on an external market maker.
With a little bit of planning and awareness, liquid mining and Liquidity Pools may provide a decent income in addition to trading on centralized crypto exchanges.
