Heard people talking about liquidity pools but have no idea what they are on about? In this blog we will simply define and explain it.
A Simple Definition Of Liquidity Pools
A liquidity pool plays a fundamental role in the functioning of a liquid decentralized finance system (DeFi). It is a pool of cryptocurrency assets governed by “smart contracts” which allow people to trade cryptocurrency on the blockchain.
Why Do We Need Liquidity Pools?
Traditional marketplaces operate by utilizing order books. Order books list the stocks that can be bought and sold, each at nominated values, and using a matching engine to facilitate the orders. DeFi trading has no centralized party acting as an intermediary between trading partners. The consequence is expensive “gas fees” paid to blockchain miners to verify transactions. It also stretches the capacity of most blockchains which are not designed to handle millions of daily transactions. The solution to this problem is Automated Market Makers (AMMs) and their liquidity pools.
A Deeper Dive Into Liquidity Pools
An AMM is basically a virtual market which is always open to quote a price between two assets. They are simple and easy to use and an intrinsic part of the blockchain functionality. An AMM is the virtual version of an order book exchange. But unlike the traditional version, when you are selling, you don’t need to wait for a buyer or agree on a price. That is all thanks to liquidity pools! The value of an asset you want to buy or sell is set by the platform’s exchange rate which is determined by a formula. Your cryptocurrency is then either added or withdrawn from the liquidity pool. Liquidity pools are sustained by the contributions or investments of liquidity providers (LPs). In exchange for providing liquidity to the pool, LPs are paid fees from the trades their pool facilitates. Anyone can contribute to a pool, essentially allowing them to become the banker or market maker! These are some of the world’s biggest Automated Market Makers:
- Curve DAO
- Bancor Network
Investment Strategies In A Liquidity Pool
Besides simply trading cryptocurrency, there are a number of investment strategies you can employ with liquidity pools. Many of them can be extremely lucrative but can also carry significant risk including impermanent loss which is when the value of a token rises or falls after you have deposited it into a liquidity pool.
Yield Farming – this is investing cryptocurrency in the liquidity pool of a blockchain network with the goal of achieving the highest possible yield. This carries the greatest potential reward but is also the riskiest strategy.
Yield Staking – this means investing cryptocurrency in the liquidity pool of a blockchain network that uses Proof of Stake (PoS) as a consensus algorithm with the long term goal of the security of that blockchain.
Liquidity Mining – this is an investment strategy in a DeFi protocol where participants contribute to liquidity pools in exchange for a share of the fees earned and newly issued tokens.
The History Of Liquidity Pools
2017 – Bancor becomes one of the first exchanges to remove order books, instead adopting a network of on-chain liquidity pools, pioneering the concept of AMMs.
2018 – Uniswap launched in November, popularizing the concept of liquidity pools.
2020 – Uniswap becomes the largest decentralized exchange.
The Future Of Liquidity Pools
Automated Market Makers and the liquidity pools they operate are still very much in their infancy. Most AMMs are still rather limited in the features and services they provide. Expect significant development of these exchanges in the very near future as more people turn to the blockchain and cryptocurrency as a way of doing business. This in turn should lead to lower fees, reduced risk, more liquidity and an overall better experience for everyone in the DeFi system.
Want To Know More About Liquidity Pools?
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