Liquidity pools have set a new standard for decentralized exchanges (DEX) while allowing investors to earn a return on their assets.
DeFi is a digital revolution. Anyway, you already know this from our previous lessons. Decentralized finance transforms an inefficient financial system into transparent and easy transactions. They are available to everyone and provide complete anonymity. They have the added advantage of operating without external control. With this knowledge already in hand, we will now move on to more advanced issues. One of the fundamental concepts underlying decentralized finance is liquidity pools. Over the past few years, liquidity pools have become a good way to make money. They are attracting more and more interested users. But before we get into the more complicated things, to make it easier for us, let’s explain what liquidity is.
Definition
Liquidity pools can be represented as a set of locked funds under the control of a smart contract encoded on the Blockchain. Liquidity pools mostly enable transactions between individuals without a trusted third party, such as loans, savings and crypto-asset exchanges.
They are the basis of all decentralized protocols (DEX) such as Curve Finance, AAVE and Uniswap.
Users can deposit funds into a liquidity pool, usually in the form of a token pair, to create a market between these assets. Stability is a key factor in operations at DeFi. It allows us to swap tokens, provide loans and credit.
Low and unsatisfactory liquidity levels affect the volatility of an asset. It leads to large fluctuations in its price, of course in a negative sense. The process also works in reverse – high liquidity means that the capriciousness of an asset’s price is less likely.
The use of Liquidity Pools
Liquidity pools are the most important in DeFi and have many applications. Among the most popular is the automated market maker (AMM) model. This is a type of DEX exchange protocol. It is entirely based on a mathematical formula for valuing an asset. You can already see why we needed integrals in college…☺ It does not use an order book, like centralized exchanges, which allows sellers and buyers to find an agreed price to exchange cryptocurrencies. Assets are priced according to an algorithm. Depending on the protocol, the given formula differs.
Here is an example. You own token X, which is listed on an exchange based on the AMM protocol. You want to exchange it for token Y. You direct an order to the X-Y liquidity pool and deposit the amount of token X that you specify. In return, you receive a B token, the value of which is determined by the smart contract. For such a transaction to be possible, the liquidity pools must have a sufficient number of asset pairs to swap. That is, they must have very high liquidity in this case of both our X and Y tokens that we want to exchange.
LIQUIDITY POOLS – EARNING
An interesting fact about liquidity pools is that anyone can make money from it. For a liquidity pool to be large, users need to deposit their funds in it. Here comes another concept used for this – yield farming. This is the process of depositing cryptocurrencies into a pool in exchange for a predetermined reward. This action can be compared to depositing money in a savings account or interest in a bank account. A user who deposits their currencies into a liquidity pool is called a liquidity provider. The rewards paid to users come from the token exchange that takes place in the pool. They are distributed proportionally among the providers, considering their total share of the pool.
The profit you receive from providing tokens to the pool varies depending on the protocol, the pool in question, the number of coins deposited and market conditions. Some have a high rate of return, while others have high volatility and risk.
LP tokens in DEFI?
As you already know, anyone can deposit assets within a liquidity pool. When an investor wants to add liquidity, they add a pair of assets, each of which has an equivalent value. Take, as an example, a trader who would like to deposit $400 into a liquidity pool on the ETH/USDT pair; then he deposits $200 in ETH and $200 in USDT. In return, he receives liquidity provider tokens – LP tokens – which are like a deposit slip, confirming in a smart contract that the investor has deposited x$ into the liquidity pool.
When a person trades, the transaction fee is deducted from the assets the trader sends to the contract and added to the liquidity pool after the trade. This portion added to the liquidity pool increases the value of the LP tokens: these are the fees the trader receives for contributing to the liquidity. Traditionally, DEXs have fees ranging from 0.03 to 0.05% per trade, allowing liquidity providers to earn between 3-10% annual interest.
Most DEXs offer the option to farm their native token to attract users to their platform. To achieve this, a trader will need to stake their LP tokens and will receive native protocol tokens in return, such as UNI on Uniswap. This strategy is called yield farming.
USE OF LIQUIDITY POOLS
- Production of synthetic tokens
To mint synthetic tokens, liquidity pools are required. Initially, cryptocurrencies must be generated as collateral for the liquidity pool. This one needs to connect to a trusted oracle. As you remember from our previous lessons, oracles are services provided by third parties. They provide smart contracts with information from the outside world. They are the bridge between blockchain and the real world.
- LM
That is, liquidity mining. Also referred to as yield farming. It allows your crypto to earn a passive income. Many platforms use the concept of pools. They automatically generate profits from pooled assets and pay the LP a reward as a yield. With LM, profits or new tokens are proportionally distributed to users based on their share of the pool.
- Streamlining design and management
Many projects, especially those based on the blockchain, vote on important issues using a token. To build their consensus or propose some management proposal. At this point, liquidity pools can be used. With them, it is possible to collect funds from users and force consensus that is required to maintain or develop DeFi protocols.
Risks of liquidity pools
Unsustainable loss. This is the most common risk that liquidity providers can face. It means that the value of the fiat assets you deposit in the system may lose value over time. Unfortunately, this loss is an inevitable part of the AMM concept. It occurs whenever the price of assets in the pool changes. Unfortunately, more change equals more loss. However, if you are patient, you can minimize this loss. If you notice a decline, don’t panic and don’t withdraw your funds right away. Remember – there is always a chance to rebound.
Another risk is smart contract. The asset added to the pool is controlled by a code. As it is in a decentralized system – there is no middleman. If an error occurs at this point – often beyond your control – then you lose your coins forever.
As a user, also beware of projects where the liquidity pool is managed by developers. This is when the community of the respective system has no control over it. This increases the risk of malicious actions by the service provider, e.g. taking control of all pool assets.
SUMMARY
With knowledge and proper calculations, using liquidity and LM pools can help you earn a pretty decent income. It is one of the basic concepts that is strongly associated with decentralized finance. It allows you to trade, borrow and even generate profit. Apart from profit and AMM, other segments of DeFi also work thanks to liquidity pools.
Study the topic carefully before taking any action regarding participation in liquidity pools. Develop your own strategy and carefully calculate the risks that this investment entails.
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