Decentralized Finance (DeFi) has resulted in a surge in on-chain activity. DEX volumes can compete significantly with centralized exchange volumes. DeFi protocols are estimated to be worth around $15 billion by December 2020. New product categories are rapidly entering the ecosystem.
But what enables all of this growth? The liquidity pool is one of the key technologies underlying all of these products.
A liquidity pool is a collection of funds that have been locked up in a smart contract. Liquidity pools are used to support decentralized trading, lending, and a variety of other activities that we will discuss later.
Many decentralized exchanges (DEX), such as Uniswap, rely on liquidity pools. To form a market, users known as liquidity providers (LP) combine an equal value of two tokens in a pool. They earn trading fees on trades that occur in their pool in proportion to their share of total liquidity in exchange for providing their funds.
AMMs have made market creation more accessible because anyone can be a liquidity provider.
Bancor was one of the first protocols to use liquidity pools, but the notion gained traction with the popularity of Uniswap. SushiSwap, Curve, and Balancer are among the more popular Ethereum exchanges that leverage liquidity pools. These venues' liquidity pools contain ERC-20 coins. PancakeSwap, BakerySwap, and BurgerSwap are BNB Smart Chain (BSC) analogs, with pools containing BEP-20 tokens.
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Crypto is required for any economic activity to take place in DeFi. And that crypto needs to be supplied in some way, which is exactly what liquidity pools are designed to achieve.
When a user sells token A in order to purchase token B on a decentralized exchange, they rely on tokens from the A/B liquidity pool given by other users. When they purchase B tokens, there will be fewer B tokens in the pool, causing the price of B to rise. That is basic supply and demand economics.
A liquidity pool is a collection of funds that liquidity providers put into a smart contract. When you execute a deal on an AMM (Automated Market Maker), you do not have a typical counterparty. Instead, you are trading against the liquidity in the liquidity pool. There does not need to be a seller at that time for the buyer to buy; only adequate liquidity in the pool is required.
Of all, liquidity must come from someplace, and anyone might be a liquidity provider, thus they may be considered your counterparty in some ways. However, it is not the same as in the order book paradigm because you are interacting with the contract that rules the pool.
So far, we've primarily talked about AMMs, which have been the most prominent application of liquidity pools. However, because pooling liquidity is such a simple notion, it may be applied in a variety of ways.
One of these is yield farming, often known as liquidity mining. Users add their funds to liquidity pools, which are then used to generate income, on automated yield-generating platforms like yearn.
Distributing fresh coins to the proper individuals is a difficult task for cryptocurrency projects. One of the more successful ways has been liquidity mining. To put it simply, tokens are awarded algorithmically to users that deposit their tokens in a liquidity pool. The freshly created tokens are then distributed proportionally to each user.
Insurance against smart contract risk is another burgeoning DeFi business. Liquidity pools are also used in many of its implementations.
Another, perhaps more cutting-edge, application of liquidity pools is tranching. It's a traditional finance concept that involves categorizing financial goods based on their risks and returns. These products, as expected, allow LPs to set tailored risk and return profiles.
If you give liquidity to an AMM, you must understand the concept of impermanent loss. When you provide liquidity to an AMM, you lose money when compared to HODLing.
You are probably exposed to temporary loss if you provide liquidity to an AMM. It might be small at times and large at others.
Another consideration is the risk of smart contracts. When monies are deposited into a liquidity pool, they become part of the pool. While there are no middlemen holding your assets, the contract itself might be considered the custodian of those funds. If there is a glitch or an exploit, for example, through a flash loan, your funds could be lost forever.
As the popularity and demand for liquidity pools grow at an exponential rate, the future of the cryptocurrency and DeFi industries appears bright. Using these pools, crypto transactions, for example, no longer need to wait for matching orders and may be designed through contracts. Liquidity pools also make the DeFi area more accessible to new customers while resolving difficulties with crypto market liquidity.
Furthermore, the pools present fresh opportunities for novice traders entering the DeFi market and assist them in overcoming trust problems while trading. These pools are likely to power the crypto market and become the main technologies driving the DeFi technological stack, with smart contracts, decentralized trading, lending, and yield production.
Despite this risk, liquidity pools are nevertheless regarded as extremely safe. In any other circumstance, they are extremely profitable. Less volatile liquidity pools are less prone to experience temporary loss. Before investing in any cryptocurrency, it is critical to employ risk management measures.
Fees are earned by liquidity providers from transactions on the DeFi platform on which they provide liquidity. Transaction costs are divided equally among all liquidity providers in the pool, therefore the more crypto assets you stake, the higher your fees will be.
Liquidity mining has proven to be extremely popular among investors since it generates passive income, which means that you may profit from cryptocurrency liquidity mining without having to make active investment decisions along the way. Your overall benefits are determined by your participation in a liquidity pool.