Following the rise of cryptocurrencies, decentralised finance (DeFi) has also gained huge traction. It aims to decentralise financial services such as lending, borrowing and exchanges that were originally found in traditional institutions. However, for new investors in the market, the underlying technologies that make the DeFi ecosystem possible are a mystery to them. One of the most fundamental parts is the liquidity pools, which help users facilitate trades without a middleman.
It hasn’t always been this way. Before DeFi redefined liquidity pools, things were extremely exclusive. Think of it like attending a party—you had to know the host and follow a ridiculous dress code you don’t like before you can get in. But now, you’re at a party where things are more easy-going. You can have fun without worrying so much about rules.
To learn more about liquidity pools in DeFi, continue reading below!
Define liquidity pools: What’s it about?
Before getting started with the topic at hand, you have to understand that the finance industry operates on liquidity. Financial systems will immobilise when available funds become scarce to prevent traders from hitting their market goals.
This is where a liquidity pool comes into play. It is a collection of funds or digital assets locked within a smart contract and can be used for loans, exchanges and other types of financial transactions. Liquidity pools have been considered the backbone of several decentralised exchanges (DEX) like Uniswap and SushiSwap. This is because they allow users to purchase crypto without the help of market makers, which provides liquidity to traditional markets.
Users within the network, also known as liquidity providers (LP), add an equal value of two tokens in a certain pool to establish a market. As a reward for providing their funds, they receive trading fees that occur in their pool. They will get a proportional share of the total liquidity.
How do they work?
When it comes to the DeFi ecosystem, smart contracts are the cornerstone of liquidity pools. Automated Market Makers (AMM) are changing the game by becoming the most popular use of this DeFi protocol. It is an innovation that permits on-chain trading to happen in the network without requiring an order book. Since there are no third parties involved in trading, traders can freely find their ground on token pairs that would be illiquid on order book exchanges.
For instance, when you’re trading on an AMM, no counterparty would execute the trade. You’re executing the trade against the liquidity in the liquidity pool itself. This means that you don’t need a seller to buy or trade because sufficient liquidity in the pool is already enough.
Let’s say you’re trying to sell token A to purchase token B on a DEX. In this scenario, you will have to rely on tokens included in the A/B liquidity pool provided by users. If someone buys token B, the number of these tokens will now be reduced so their price will go up. If you understand the concept of supply and demand, then you’re already off to a good start.
Real-life uses of liquidity pools
In 2020, some of the best liquidity pools in the market have gained so much popularity since they provide real-life uses for traders. With the promising concept it provides, there’s no doubt that traders are navigating financial systems with ease.
Take a closer look at some of the best use-cases of this innovative technology:
Yield farming or liquidity mining
One of the most interesting use cases of liquidity pools is yield farming. This is where users contribute funds to a specific pool that are used to generate income on automated yield-generating platforms like Yearn Finance. That way, users participating in DEX platforms have a way to maximise their returns.
If you’re a yield farmer, you can employ more complex strategies to make the most of your trades. For instance, you can transfer your digital assets from one loan platform to another so you can increase your desired profits.
Liquidity pools can be used as leverage to make governance more efficient. Keep in mind that before a formal governance proposal can push through, a majority of token votes are required to establish it. However, liquidity pools provide an alternative where participants can pool their funds together to rally behind a common cause, which will improve a specific protocol.
Minting synthetic assets
Another use case of liquidity pools involves the minting of synthetic assets on the blockchain. To create a synthetic token, you need to put some collateral in a pool and link it to a verified oracle.
This also paves the way for efficient token distribution by making sure that the new tokens will be distributed to the right people in various crypto projects. Newly minted tokens are dispensed according to the share of every user participating in the liquidity pool.
Tranching is considered to be one of the most cutting-edge applications of liquidity pools. It is a traditional finance concept that categorises financial products according to their risks and returns. This also allows investors to establish their investment earnings to complement their cash flow needs.
Using these financial goods, liquidity providers have the opportunity to build their own risk and return profiles.
Participate in liquidity pools in DeFi in Casino Days
There’s no denying that liquidity pools are now considered to be one of the most innovative financial technologies in the crypto sphere. It further expands the potential of the DeFi ecosystem by improving accessibility and yield farming opportunities, as well as reducing the reliance on external market makers.
Additionally, participating in liquidity pools is an ideal method for investors who want to passively generate income using cryptocurrencies. For as long as you’re in the hands of a reliable platform and pools, then leveraging on this DeFi protocol can further optimise your gains.