Liquidity Pools gives us endless possibilities for a decentralized environment. These are behind the success of DeFi ecosystem. Let us learn about Crypto Liquidity Pool and how they work?
What is a Liquidity Pool?
A liquidity pool is a collection of decentralized assets. It is a type of ‘bank’ where crypto assets piled together and locked in the pool through Smart Contract. You can deposit one crypto asset and borrow another one from this pool.
Liquidity Providers or Market makers are the ones to create these pools. They use their funds to add, usually a pair of, equal value of tokens to create a market. Doing this they create a market for the token and make it more accessible at fair pricing value. Mainly Banks, Hedge Funds, Institutional Investors, Trading Firms etc. act as Liquidity Provider and use the Automated Market Maker (AMM) protocol.
AMM’s allow digital assets trading in an automated, decentralized way by use of Smart Contract in a Liquidity Pool.
Difference Between Traditional Market Making and Liquidity Pools
Traditional markets use Order Books to match orders through a matching engine. Orders are executed through Order Books. Centralized Exchanges rely on Order Books for efficient trading. However, with Decentralized Exchange, Order Books cannot be used because there is not central authority.
Also, it is not possible for some blockchains to handle required throughput for trading billions of dollars daily. Ethereum is one of the most popular examples where you have to use cross-chain bridge to trade assets on the network.
Now let us talk about how do Crypto Liquidity Pools Work?
Crypto Liquidity pools invite investors to stake their assets in the pool. They in-turn receive trading fees or crypto rewards. These are basically to create market for illiquid crypto assets which would be difficult to do so in traditional financial markets. When an investor puts his funds in the pool, he receives Liquidity Provider (LP) tokens. These are valuable tokens and one can use them anywhere in the DeFi ecosystem.
Let us understand like this – Mr. A has invested some funds in the Liquidity Pool. Now he got some LP tokens in proportion to the funds he staked in the pool. Whenever someone trades through this Liquidity Pool, the investors get a fee. Now Mr. A would receive a fractional fee of the trade. The fee is distributed proportionally to every investor in the pool. If Mr. A want to pull his funds from the pool, his LP tokens must be destroyed.
AMM is the underlying algorithm which conducts all the transactions in a liquidity pool. Automated Algorithm usage means no manipulation of market price or anything else. Therefore, they maintain fair market price for tokens. They also ensure that the pool consistently provides liquidity by maintaining the cost and ratio of token according to the supply and demand.
Adaptions of Crypto Liquidity Pools
As said above, the main purpose of these pools is to provide liquidity to the tokens and create a market for them. AMM’s are the most popular use of Liquidity Pools. However, there are many uses of Liquidity Pools.
Yield farming has become very popular. Investors pool their assets to earn yields. There are incentivized pools to earn high number of LP tokens, also known as Liquidity Minting. Basically, you lock your crypto assets in a blockchain protocol to generate tokenize rewards or ‘Yields’.
Insurance is another sector gaining popularity in DeFi. You can get insurance against Smart Contract risks through Liquidity Pool. There is another sector gaining emergence is minting synthetic assets on blockchain. These are also executed through liquidity pools. Hence, the possibilities are endless. Liquidity pools are the next big thing and there are many more uses yet to be discovered.