At some point most DeFi newbies will find themselves seeking to grasp the concept of Liquidity Pools. In searching for an understanding, it helps to know that the current DeFi ecosystem can only exist with the aid of Liquidity Pools. This article aims to provide you with sufficient information about Liquidity Pools to bring your search to an end.
What is a Liquidity Pool?
A liquidity pool in the simplest sense is a digital vault where two assets are kept for the purpose of creating a trading pair and making them instantly available for the market. Crypto Liquidity pools are a bit complex than this. In Crypto, Liquidity Pools are a crowdsourced pool of digital assets (usually a pair) locked within a smart contract. This serves to keep the market flowing as these assets will be made instantly available for trades.
Liquidity Pools are the foundation of Decentralized Exchanges (DEXs) as they allow for a secure automated operation, removing the need for a central authority. They replace the traditional order books employed by centralized exchanges to facilitate liquidity in the market. With order books, funds are held by a central body. With Liquidity Pools, exchanges are made instantly with exchange rates being determined by an Automated Market Maker (AMM).
The Importance of a Liquidity Pool
From time, the ease of converting investments to cash has always been a factor for determining a good investment. Liquidity Pools serve to ease the exchange of crypto assets. These pools are mostly employed by DEXs and each pool comes in pairs of two different assets.
To assess the quality of a token a huge emphasis is given to the size of the liquidity. This is due to a phenomenon called Slippage, which can be described simply as the difference between the predicted price of a trade and the final price after trade completion. This difference can be positive or negative, but the latter is usually the case. A negative slippage occurs in periods of high volatility which is a characteristic of a pool with low liquidity. Hence why liquidity size is an important criterion before investing.
How does a liquidity pool work?
To understand how a Liquidity pool works, we need the prerequisite understanding of an Automated Market Maker. Firstly, a market maker is simply any entity that creates a market by creating buy and sell orders. Before liquidity pools, individuals and entities were given permission to create buy and sell orders (market-making) by a central authority, the host Exchange. These trades and transactions were overseen by the Central authority to ensure security of trades, hence centralized exchanges. Since Decentralized exchanges make use of Liquidity pools as an alternative to traditional market making, a price determining mechanism is employed, Automated Market Maker (AMM). This is simply a mathematical formula that is used to determine asset price based on the ratio of the two assets in a liquidity pool. Different formulas are employed by various DEXs.
With the understanding of AMMs, the function of Liquidity pools can be grasped easily. In a concise idea, Liquidity Pools are made up of two different digital assets. Incentives are used to entice users into providing these assets in the liquidity pool. Users deposit an equal amount of assets into the pool. For example, 50% BNB and 50% LEDU to the BNB/LEDU pool. These assets are therefore locked in a smart-contract. Based on the ratio of both assets in the pool, exchange price is determined by an AMM.
Advantages of Liquidity Pools
Liquidity pools are advantageous to both market makers and takers.
Takers: Secure exchanges are made instead of trades. Since there are no governing bodies, fees are considerably reduced. With the use of smart-contracts exchanges are instant without delays. And no need for negotiation skills as prices are automatically determined.
Makers: For users to vest assets into a pool some incentives are required, and Liquidity Pools provide various means by which users can gain by depositing assets into a Liquidity pool. Liquidity providers can earn passive income by pledging their tokens in Yield farms, Staking pools or Liquidity mines, Governance token.
Yield Farming: Yield farming is simply the locking up of tokens in a smart-contract liquidity pool like LEDU/BNB to earn passive income. These locked tokens are used as loans, and also serve to maintain liquidity.
Liquidity mining: This idea is similar to staking and was first introduced by Compound, it rewarded users with COMP its governance token for providing liquidity. A liquidity miner can earn incentives in the form of the project’s native token or, in some cases, the governance rights it represents.
Staking: This incentive involves locking up assets to serve as Proof of Stake on blockchain networks that employ the Proof of Stake consensus mechanism. Stakers are selected to validate transactions on these blockchains in exchange for an annual percentage yield (APY).
Liquidity Pools Risks
As with benefits comes the risks of Liquidity Pool. Some of which include flaws in the smart-contract, temporary loss, and access risks.
Smart contract-based risks: Since liquidity pools are secured and executed by a smart contract without any central authority, flaws in a smart-contract could lead to exploits, posing serious risk to liquidity providers.
Temporary Loss: This can be described as a loss incurred due to slippage. Recall that slippage occurs when there is high volatility in the Liquidity pool. Temporary loss is simply when the price of an asset experiences a negative change from the original purchase price. Reducing the dollar worth of your asset unlike simply holding.
Access Risks: This simply refers to backdoor accesses within the smart-contract code. Sometimes project creators enable these backdoor accesses to allow malicious practices like seize control of funds in a pool.
Liquidity pools can be described as the backbone of the DeFi space. Along with the implementation of smart contracts they allow for a fully decentralized operation. Liquidity pools have become one of the best means for a secure passive income. With the DeFi space experiencing tremendous growth, it is likely there would be more innovations to improve the concept of Liquidity Pools.