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What are Liquidity Pools in Decentralized Finance (DeFi)?

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In this modern era, liquidity pools have formed an integral part of the DeFi or decentralized finance contracts. It allows several popular dApps or decentralized finance applications to offer a great way for cryptocurrency investors to gain better profit margins on their crypto assets. In our crypto market analysis, we have estimated it to leap over the value of the $30 billion mark held in the liquidity pools.

So, what do these liquidity pools imply, and why do they play such an integral role in the DeFi platform?

Our post today will explain everything related to the liquidity pool, how they work, and why they are vital in the DeFi ecological system.

An overview

Liquidity pools have evolved as the game-changing transformation in the DeFi or the Decentralized Finance, facilitating crypto trading on the DEX or the Decentralized Exchanges and offering liquidity through the collected funds being locked under the smart contract.

Similar to any conventional stock exchanges, trading on centralized crypto exchanges is based on the model of an Order Book where both the buyers and sellers are placing orders. The buyers try buying an asset at the lowest possible price, while the sellers try selling it at higher prices. Both the buyer and the seller agree on the price to facilitate trading.

What happens when neither the buyer nor the seller agrees upon the price? Or what happens if there is no sufficient liquidity for executing the order? It is where the approach of Market Makers comes into action. The market makers facilitate trading by willingly buying or selling a specific asset, offering liquidity, and allowing the traders to trade without waiting for any other buyer or seller to arrive.

In DeFi or decentralized finance, excessive reliance on external market makers might result in relatively expensive and slower transactions, which is addressed through the liquidity pools.

How do liquidity pools function?

Under Decentralized finance, smart contracts start governing whatever takes place in the liquidity pool. The AMMs or the Automated Market Makers have used liquidity pools extensively. These are used by Uniswap, where each asset is facilitated by swap through the smart contracts resulting in better price adjustments.

The fundamental liquidity pool creates a market of specific pairs of assets on the decentralized exchanges. The liquidity provider sets the basic price equally supplying to both assets whenever the liquidity pool is established. The approach of an equal supply to both assets stays the same across every other liquidity provider willingly supplying liquidity into the pool.

The liquidity providers’ benefits are proportional to the amount supplied to the pool, and the transaction fee is proportionally distributed among liquidity providers whenever trading is facilitated.

There are varied smart contracts allowing varied use cases of liquidity pools. For example, the CMM or the Constant Market maker algorithm ensures constant liquidity supplies. The token ratios within the liquidity pool start dictating the cost of the assets.

For instance, whenever you purchase ETH through ETH pool/DAI, the ETH supply is minimised from this pool, and the DAI supply increases proportionally. It, therefore, increases the cost of ETH and decreases the DAI prices.

There are a couple of smart contracts incentivizing the liquidity providers with some additional tokens, and the process is known as liquidity mining.

Uses of liquidity pools

Until now, we have stated about the AMMs popularly used within the liquidity pool. But, as we have already mentioned, liquidity pools are an extremely easy concept, so it is used in several ways.

Liquidity mining or yield farming is one of the several ways. The liquidity pools form the fundamentals of the automated yield-generating domain, such as yearning, where the users add their funds to the pools, which are then used to generate better yields.

In the crypto market, the distribution of new tokens through the hands of the proper individuals is a significantly complex process. Liquidity mining has turned out to be a highly successful approach. Generally, some tokens are algorithmically distributed among the users who place their tokens within the liquidity pools. Therefore, the newly minted tokens get distributed proportionally across the pool share for each user.

Remember that these are the tokens from other liquidity pools known as pool tokens. For instance, if you offer liquidity to Uniswap or lending funds, you will receive tokens representing your share within this pool. You might start depositing these tokens into other pools while earning a return. These chains are becoming highly complex since the protocols start integrating with the pool tokens of the protocol into their products.

We could consider governance as one of the use cases. In a few circumstances, there is a greater threshold of votes for the token to place forward a formal governance proposal. The participants can start rallying behind the general cause rendering greater importance for this contract if the funds get pooled together.

The smart contract risk is the other part of the evolving DeFi, and liquidity pools back several of their implementations.

Tranching is yet another innovative use of the liquidity pool. The approach borrowed from conventional finances involves the division of the financial products on the basis of the returns and the risk, as you might expect that these are the products allowing the LPs to pick the customised vulnerability and return profiles.

The minting of the synthetic crypto asset on the blockchain depends on the liquidity pools. Adding a couple of collaterals to this liquidity pool and connecting to a reliable oracle will help you gain a synthetic token attached to your chosen asset. It is more complex than it might appear; however, the basic plan is extremely simple.

The uses are endless, many of which still need to be unveiled. Everything relies on the creativity of the DeFi developers.

Top Crypto Liquidity Pools in 2022 

  • Uniswap – Decentralized ERC-20 token liquidity pool supporting ETH and ERC-20 token contracts in 1:1 ratio.
  • Balancer – Decentralized liquidity pool, which also serves as a price sensor and non-custodial portfolio manager.
  • Bancor– Ethereum based platform using algorithmic market-making methods for leveraging pooled liquidity.
  • Curve Finance – Ethereum based decentralized liquidity pool tailored for stablecoin trading.
  • Convexity Protocol – A decentralized crypto liquidity pool tailored for ERC-20 tokenized options contract.
  • DeversiFi – Decentralized, non-custodial liquidity pool powered by STARKEX smart contract.
  • KeeperDAO – Ethereum based DeFi protocol, serving primarily in the role of an on-chain DeFi underwriter.
  • Kyber Network – Ethereum based on chain liquidity protocol, which empowers dApps for providing liquidity.
  • OIN Finance – New liquidity pool with a focus on multiple DeFi services.
  • ICTE – Decentralized liquidity pool tailored for inter-exchange trading.

Risks associated

Transient losses are considered one of the major risks related to liquidity pools. The outcome is a short-term fund loss by the liquidity providers due to the volatility of crypto trading.

If the liquidity pool is bigger than the trade, the difference between the expected price is smaller when the trade gets executed. It is a price difference that is considered slippage. A larger liquidity pool accommodates significant trading while creating fewer slippages, resulting in adequate trading experiences.

Closing thoughts

Liquidity pools are considered one of the crucial technologies behind the recent DeFi technology stack. They would allow decentralized trading, yield generation, lending, and more. These smart contracts power almost every part of the DeFi platform and will continue doing so.

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