How DeFi Liquidity Pool Works
Written by TUDJE Gabriel
The idea of a liquidity pool has not only made the DeFi ecosystem the center of attraction for crypto users but has also solved the problem of fast liquidation of assets facing centralized exchanges like Coinbase and Binance.
DeFi liquidity pool allows decentralized exchanges like Uniswap, PancakeSwap, BakerySwap, and Zeroloss to offer continuous automated liquidity to users. And although liquidity pools ease trading activities in DeFi, they still pose some risks to potential investors.
This article explains what liquidity pools are, how they work, how you can benefit from them, and the risk involved.
What is a Liquidity Pool?
To understand what “liquidity pool” is, you need to first understand the meaning of the word “liquidity”.
Liquidity means the ease with which an asset can be converted into cash. An asset can be liquid or illiquid, depending on the market conditions and medium of exchange.
Now you understand what liquidity is, what then is a liquidity pool? A liquidity pool is a collection of assets kept and locked in a smart contract to allow users to swap their cryptocurrencies or tokens with ease even if there are no buyers or sellers at that point in time.
This is opposed to the “order book” method used by most centralized exchanges where a buyer or seller needs to be present for a trade to take place. So while trades take place between a buyer and a seller in the order book method, the liquidity pool executes trades between the user and the smart contract, making trading fees cheaper and liquidation faster.
Note that the funds locked in the smart contract are provided by market makers or what is called “Liquidity providers”. These liquidity providers lend their money to the pool and in return, earn trading fees from trades going on in the pool.
From the foregoing, you will agree that liquidity pools have made trading, lending, and borrowing in decentralized finance easy and faster.
How Do Liquidity Pools Work?
Liquidity pools work by rules. One of the rules is that the total dollar value of both asset types locked in the smart contract must be the same.
When they are not the same, the token type that has a larger total value will be sold to buy the token type with the smaller token value, until the rule of token equality in value is met.
Another rule is that if both tokens constantly move in different directions or rates, the result will be fewer high-value tokens and more low-value tokens.
The liquidity pool also works using the AMM (automated market marker) model which allows crypto users to automatically trade their cryptocurrencies without waiting to fill a buy and sell order.
The liquidity pool’s sole aim is to allow users easily exchange their assets or convert them to cash. The funds lent by liquidity providers could be USDT-ETH, USDC-ETH pair, or any type of cryptocurrency pair.
Note that if there are more liquidity providers to the pool, the trading fees would be distributed automatically to all liquidity providers according to their stake size.
Anyone can be a liquidity provider. Liquidity providers also receive a new token called a pool token as part of their reward. These pool tokens are burnt whenever the providers want to withdraw their stake or funds from the pool.
You can see that the liquidity pool works in a far more efficient way to provide liquidity for crypto traders and investors.
Why Use Liquidity Pools?
As a crypto trader, Defi liquidity pools give you access to a never-ending supply of liquidity where you can easily trade, borrow and lend your cryptocurrency.
You can also benefit from Defi liquidity pools by investing your funds as a liquidity provider, where you will earn trade fees from transactions going on in the pool.
Some projects in the DeFi ecosystem like Zeroloss, help liquidity providers by ensuring their rewards remain large. They also help reduce the risk of slippage in order to create a better trading experience for users.
What are the Risks Involved in Liquidity Pools?
One of the risks involved in the liquidity pool is that the smart contract holding the funds is prone to bug or code errors. This can give cybercriminals the opportunity to steal funds that might never be recovered.
Another risk is that some DeFi projects give access to developers. These developers sometimes don’t only have permission to change the rules of the pool but also have access to the smart contract code. And in a situation where the developer is fraudulent, he can take control of the funds in the pool and run away with it.
The volatile nature of cryptocurrencies also poses a big risk to the functionality of liquidity pools. Liquidity providers can encounter what is called impermanent loss which sometimes leads to a permanent loss. But depending on the size of the fluctuation it is possible to offset some or all of this loss with transaction fee rewards.
Apart from being core technologies behind decentralized finance, liquidity pools make decentralized trading, and lending possible. Liquidity pools hold to the rule of token value equality to ensure pool balance, they work using the AMM model, provide faster liquidation of assets, and reward investors with pool tokens. Although they offer crypto traders a vast supply of liquidity, there are still some risks associated with the smart contracts that power the DeFi ecosystem. DeFi liquidity pools are what make DeFi unique and accessible.
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