Liquidity Fund in Crypto | Detailed explanation for beginners
In this post, you will learn what DeFi liquidity pools are and how they work. Detailed explanation for beginners
Decentralized finance ( DeFi ) has sparked an explosion of on-chain activity. DEX volumes can significantly compete with the volume on centralized exchanges. As of December 2020, DeFi protocols have almost $15 billion. The ecosystem is rapidly expanding with new products.
But what makes all this expansion possible? One of the leading technologies behind all these products is the liquidity pool.
Liquidity pools are one of the foundational technologies underlying the current DeFi ecosystem. They are an integral part of automated market makers ( AMMs ), lend-to-loan protocols, crop farming, synthetic assets, chain insurance, blockchain gaming; The list goes on and on.
The idea itself is straightforward. The liquidity pool is basically a pool of money. But what can you do with this stack in an unresolved environment where anyone can increase their liquidity? Let’s explore how DeFi echoed the idea of liquidity pools.
What is a liquidity fund?
The liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and many other features, which we’ll discuss later.
Liquidity pools are the foundation of many decentralized exchanges (DEXs), such as Uniswap. Users, called Liquidity Providers (LPs), add an equal value of two tokens to the pool to create a market. In exchange for providing their funds, they receive commissions for transactions that take place in their pool in proportion to their share of the total liquidity.
AMM has made marketing more affordable since everyone can be a liquidity provider.
One of the first protocols to use liquidity pools was Bancor, but this concept gained more attention with the popularization of Uniswap. Some other popular exchanges that use liquidity pools on Ethereum are SushiSwap, Curve, and Balancer. The liquidity pools in these locations contain ERC-20 tokens. Similar equivalents on Binance Smart Chain (BSC) are PancakeSwap, BakerySwap, and BurgerSwap, where the pools contain BEP-20 tokens.
Liquidity pools compared to order books.
To understand how liquidity pools differ, let’s take a look at the basic building block of e-commerce: the order book. In a nutshell, a margin book is a collection of open margins for a given market.
The system that combines the orders with each other is called a matching mechanism. Along with the matching mechanism, the order book is the core of any centralized exchange (CEX). This model is ideal for facilitating efficient trades and allows you to create complex financial markets.
However, DeFi trading involves on-chain transactions without a centralized party holding the funds. This is a problem when it comes to ordering books. Each interaction with the order book requires a gas fee, which makes transactions very expensive.
It also makes the job of market makers, the traders who provide liquidity to trading pairs, extremely expensive. But above all, most blockchains cannot handle the bandwidth required to exchange billions of dollars every day.
This means that exchanging order books on a blockchain is practically impossible on a blockchain like Ethereum. You can use sidechains or two-layer solutions, and you’re on your way. However, the network cannot handle the bandwidth in its current form.
Before proceeding, it should be noted that there are DEXs that work very well with chain order books. Binance DEX is based on the Binance Chain and is specifically designed for fast and cheap trading. Another example is Project Serum, which is based on the Solana blockchain.
However, since most assets in the crypto space are on Ethereum, you can’t trade them on other networks unless you’re using some kind of cross-chain bridge.
The role of crypto-liquidity pools in DeFi
Cryptocurrency pools play an important role in the decentralized finance (DeFi) ecosystem, particularly when it comes to decentralized exchanges (DEXs). Liquidity pools are a mechanism by which users can pool their assets into DEX smart contracts to provide asset liquidity for traders to trade currencies. Liquidity pools provide much-needed liquidity, speed, and convenience to the DeFi ecosystem.
Before the advent of automated market makers (AMMs), cryptocurrency liquidity was an issue for DEXs on Ethereum. At that time, DEX was a new technology with a sophisticated interface. The number of buyers and sellers was small, so it was difficult to find enough people willing to trade regularly. AMM solves this problem of limited liquidity by creating liquidity pools and offering liquidity providers an incentive to supply assets to these pools, all without the need for third-party intermediaries. The more assets there are in the pool and the more liquidity there is, the easier it is to trade on decentralized exchanges.
Why are cryptocurrency pools important?
Any experienced cryptocurrency or traditional trader can tell you about the potential downsides of entering the market with little liquidity. Whether it’s a small-cap cryptocurrency or a penny, slippage will be a concern when trying to enter or exit any transaction. Slippage is the difference between the expected price of the transaction and the price at which it is executed. Slippage is more common during periods of increased volatility and can also occur when a large margin is called, but at the selected price, there is not enough volume to sustain a margin offer request.
This bid market price, used at times of high volatility or low volume in the traditional order book model, is determined by the distribution of buy orders and order books for a given trading pair. This means that this is the middle ground between the price at which sellers are willing to sell an asset and the price at which buyers are willing to buy it. However, low liquidity can cause more slippage, and the executed trading price can significantly exceed the original market order price, depending on the asset’s bid-ask spread at any given time.
Liquidity pools aim to solve the problem of illiquid markets by encouraging users to provide cryptocurrency for part of the trading fees. Trading through liquidity pool protocols, such as Bancor or Uniswap, does not require a match between buyer and seller. This means that users can simply exchange their tokens and assets using the liquidity provided by users and made through smart contracts.
How do cryptocurrency pools work?
The crypto operating pool should be designed to encourage crypto providers to put their assets into the pool. This is why most liquidity providers earn trading fees and cryptocurrency rewards from the exchanges they pool tokens on. When a user provides a liquidity pool, the provider is often rewarded with Liquidity Provider (LP) tokens. LP tokens can be valuable assets in their own right and can be used throughout the DeFi ecosystem in a variety of ways.
Typically, a crypto provider receives LP tokens in proportion to the amount of liquidity they put into the pool. The fractional commission is distributed proportionately among the LP token holders if the pool facilitates trading. In order for the liquidity provider to return the liquidity you contributed (plus any fees accrued on your end), your LP tokens must be destroyed.
Liquidity pools maintain fair market prices for the tokens they hold, thanks to AMM algorithms that support the price of tokens against each other in any particular pool. Liquidity pools on different protocols may use slightly different algorithms. For example, Uniswap liquidity pools use a constant product formula to maintain value for money, and many DEX platforms use a similar model. This algorithm helps ensure that the pool consistently provides cryptocurrency liquidity by controlling the cost and ratio of the relevant tokens as the required amount increases.
Agricultural yields and liquidity reserves
To create a better trading experience, various protocols offer even more incentives for users to provide liquidity by providing more tokens for certain “encouraged” pools. Participation in these stimulated liquidity pools as a provider to obtain the maximum number of LP tokens is called liquidity mining. Liquidity mining is how crypto exchange liquidity providers can optimize their income from LP tokens on a particular market or platform.
Many stimulated DeFi markets, platforms, and tools allow you to receive rewards for providing and mining liquidity through LP tokens. So how does a cryptocurrency provider choose where to put their funds? This is where farming comes into play. Farming crops is the practice of staking or locking cryptocurrencies on a blockchain protocol in order to receive tokenized rewards. The idea of increasing returns is to stake or lock tokens in various DeFi programs to generate tokenized rewards that help maximize profits. This allows the cryptocurrency exchange liquidity provider to earn high profits with slightly higher risk. Your funds are distributed among trading peers and spurred pools with the highest trading commission and LP token payouts across multiple platforms. This type of liquidity investing can automatically put a user’s funds into an asset pair with the highest return. Platforms like Yearn. Finance even automates balance risk and return options to move your funds into various DeFi investments that provide liquidity.
The unexpected value of crypto pools
In the early stages of DeFi, DEX suffered from cryptocurrency liquidity issues trying to model traditional market makers. Liquidity pools have helped solve this problem by encouraging users to provide liquidity instead of matching seller and buyer on the order book. This provided a powerful decentralized liquidity solution in DeFi and contributed to the development of the DeFi sector. Liquidity pools may have been born out of necessity, but their innovations provide a new way to provide algorithmically decentralized liquidity through user-spurred and funded pools of assets.
Final Words
Liquidity pools are one of the key technologies behind the current DeFi technology stack. They enable decentralized trading, lending, revenue generation, and more. These smart contracts power almost every part of DeFi, and will likely continue to do so.