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Liquidity pools are one of the cornerstones of the DeFi ecosystem today. It is an essential part of automated market makers (AMM), lending and lending protocols, yield farming, synthetic assets, blockchain gaming, and more.
The value of the decentralized finance (DeFi) ecosystem has already exceeded the $ 60 billion mark.
What is Decentralized Finance – DeFi?
Decentralized finance, decentralized stock exchanges, or DEX are autonomous decentralized applications (DApps) that allow buyers or sellers of cryptocurrencies to trade without intermediaries.
With the help of smart contracts, DEX manages automated books or orders (or automated markets) and trades. That makes them truly a “peer-to-peer” exchange.
In DEX, which uses on-chain order books, there are network nodes that are assigned to keep records of all orders. It also requires the work of a miner to confirm each transaction.
The advantage of DEX is the improved privacy, stronger security, and greater user control they offer to digital asset owners.
What is a “Liquidity Pool”
“Liquidity pool” is an innovation that changes the game in decentralized finance (DeFi) which facilitates trading on decentralized stock exchanges (DEX) and provides liquidity by raising funds for concluded “smart contracts”.
Why Do We Need “Liquidity Pools”?
Like traditional exchanges, trading on centralized cryptocurrency exchanges is based on the order book model, where buyers and sellers give orders. While buyers try to buy the product at the lowest possible price, sellers try to sell it as much as possible. In order for a trade to take place, both the buyer and the seller must agree on a price.
What if Neither the Buyer Nor the Seller Approaches the Price? Or, What if There is not Enough Liquidity for the Order to Be Executed?
This is where the concept of Market Maker comes into play. Market makers facilitate trading by being willing to buy or sell certain assets, thus providing liquidity and allowing traders to trade without waiting for another buyer or seller to appear. In decentralized finance (DeFi), excessive dependence on external market makers can result in relatively slow and expensive transactions. This is exactly what liquidity pools can solve.
How Do “Liquidity Pools” Work?
In decentralized finance, smart contracts manage what happens in the liquidity group. Automated market makers (AMM) are the most popular use of liquidity pools.
At Uniswap, any exchange of assets is facilitated by a smart contract and results in a price adjustment.
The basic “liquidity pool” creates a market for a certain pair of assets on a decentralized stock exchange (eg DAI / ETH). When a “liquidity pool” is created, the liquidity provider sets the starting price and equal supply of both assets. This concept of an equal amount of both assets remains the same for all other liquidity providers who are willing to be supplied with a “liquidity pool”.
Liquidity providers are encouraged in proportion to the amount of liquidity they supply to the liquidity fund. When trading is facilitated, the transaction fee is distributed proportionally among all liquidity providers. Different smart contracts allow for different use cases.
For example, the Constant Market Maker algorithm ensures a constant supply of liquidity. The ratio of tokens in the Liquidity Group dictates the price of assets. For example, when you buy ETH from a DAI / ETH pool, the ETH offer decreases from the pool, and the DAI offer increases proportionally. This will increase the price of ETH and reduce the price of DAI. Some smart contracts also encourage liquidity providers with some additional tokens. This process is called “liquidity mining“.
Practical Use of “Liquidity Pools”
Uniswap, the DeFi protocol used to exchange cryptocurrencies, encourages the basics of using the “liquidity pool”. However, many other decentralized exchanges rely on the fundamental principle of the “liquidity pool”, while differing in terms of their practical use cases.
For example, the concept behind Automated Market Makers (AMMs) does not work well for assets with similar prices as stablecoins or wrapped tokens. Curve, the exchange of liquidity funds on Ethereum, managed to offer lower fees when exchanging assets of similar price by applying a different algorithm. The Balancer of the Automated Market Maker Protocol (AMM) has figured out that the “liquidity pool” does not necessarily have to be limited to two assets. Provides up to 8 tokens in one liquidity store.
Withdrawals from “Liquidity Pools “
Permanent losses are one of the risks of the “liquidity pool”. The result is a temporary loss of liquidity provider funds due to the instability of the trading pair. The larger the liquidity fund in proportion to the trade, the smaller the difference between the expected price at which the trade is performed. This difference in price is called “slippage”. Because larger “liquidity pools” can accommodate more significant deals, they create fewer slippages, resulting in a better trading experience.
To summarize, liquidity pools eliminate the need for centralized ledgers, while significantly reducing dependence on external market makers to provide a continuous supply of liquidity to decentralized exchanges.