Liquidity pools explained

DeFi is changing financial narratives from what we used to know to a redefined and decentralized state. Liquidity pools have been an integral part of funding in the sector. As of January 2022, almost $200 billion have been locked up in DeFi protocols.

In this article I will be exploring the basics of the liquidity pools and how they work.

What’s a liquidity pool?

It’s a crowdsourced pool of cryptocurrencies, tokens locked in a smart contract. These tokens help provide liquidity(money) in decentralized finance.

How does it work?

There are two cryptocurrencies that make up a liquidity pool. Let’s say ETH and DAI. It’s a 50:50 ratio. For you to give your $200 to the pool. It will be ETH worth $100 and DAI worth $100.

As people buy more ETH in the pool, it raises the price of ETH because it wants to keep the 50:50 mark.

It uses an protocol known as an automated market maker which is responsible for prices of assets/tokens.

The funds deposited in the pool enables constant liquidity for transactions like borrowing, trading and lending.

Use cases of liquidity pool

  • Decentralized exchanges: is a peer to peer marketplace that connects buyers and sellers in the crypto market. It’s made possible through the creation of liquidity pools.
  • Decentralized lending: This is another popular use case. Providing loans to business and people without a third party is easy using a liquidity pool as a source of funds.
  • Tranching: Though it’s a traditional finance concept, it can also be used in deFi. It involves categorizing financial goods based on returns and risks. This allows Liquidity providers to create their return and risks profile.
  • Yield farming : is a concept in decentralized finance where a user contribute assets and tokens to liquidity pools and receive yield as profit. It helps investors make passive income.
  • Synthetic assets: A synthetic asset is a tokenized derivative that has the same value of another asset. You can create synthetic assets through the use of a liquidity pool, it just needs to be connected to a trusted oracle.

Benefits of the liquidity pool

  • Anyone can provide liquidity to a pool, there are no restrictions.
  • Trustless transactions.
  • Incentives in the form of transaction fees paid by lenders are given to liquidity providers.
  • They are able to participate in the decision-making process of the protocol.

Risks involved

  • One of the risks is a bug in the smart contract holding liquidity. It leads to a permanent loss of funds in the pool.
  • Impermanent loss is a major risk you should think about when considering liquidity pools. Impermanent loss occurs when there’s a change in the price of the token compared to when you deposited it. The larger the difference, the larger the loss. It would have been better for you to just hodl your tokens.

DeFi have created more earning opportunities for everyone but remember to do your research well before investing.

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