Liquidity Pools In DeFi And How Do They Work

Everything You Need To Know About Liquidity Pools In DeFi 

Liquidity Pools In DeFi And How Do They Work

Liquidity pools are a key component of the ecosystem. AMMs, borrow-lend protocols, yield farming, synthetic assets, blockchain insurance, blockchain games, etc., all depend on them. Tokens named LP Tokens are given to the liquidity provider (LP) in proportion to the quantity of liquidity he or she provides to the pool. Decentralized Finance (DeFi) has led to an explosion of activity on the blockchain. DEX volumes can compete with centralized exchange volumes in a meaningful way.

Trades and loans are made more efficient by using liquidity pools. Many decentralized exchanges (DEX) rely on liquidity pools, which are created by users called liquidity providers (LPs). For contributing their funds, they receive trading fees equal to their percentage of overall liquidity.

Bancor was among the first protocols to employ liquidity pools, but Uniswap brought the notion to the forefront. Also, SushiSwap, Curve, and Balancer employ liquidity pools on Ethereum. ERC-20 coins are used in the liquidity pools at these venues. 

Working Of Liquidity Pools 

The game has been transformed by the use of automated market makers (AMMs). On-chain trading is now possible without the need of an order book, which is a major breakthrough. Traders can enter and exit positions on token pairs that would likely be very illiquid on order book exchanges since no direct counterparty is required to complete trades.

A peer-to-peer order book exchange connects buyers and sellers through the order book. Peer-to-peer trading takes place on Binance DEX, for example, as trades are conducted directly between user wallets. It's a distinct experience to trade with an AMM. Peer-to-peer trading is one way to describe trading on an AMM.

The opposite side of Uniswap is not a seller in the classic sense. A pool algorithm manages your activities, rather than you. It also determines pricing depending on the transactions that occur in the pool using this algorithm. To learn more about how this works, check out our AMM article. Counterparty in some sense is someone who provides liquidity, and anyone can do this. Unlike the order book, you are engaging with the contract that controls the pool, which is different.

The Risks Of Liquidity Pools

Providing liquidity to an AMM requires understanding the notion of impermanent loss. When you provide liquidity to an AMM, you suffer a dollar value loss compared to HODLing.

Your exposure to temporary loss is likely to be high if you provide liquidity to an AMM. There are times when it is small, and other times when it is large. Smart contract risks should also be considered. A liquidity pool is created when money are deposited. The contract itself is the custodian of your cash, even if there are legally no intermediaries. If, for example, there is a fault or an exploit in a flash loan, your cash might be lost permanently.