What is Liquidity Pool?
Blockchain’s philosophy is to create a decentralized world; A world where everything is moving towards decentralization and removal of central power. One of the important achievements of this philosophy is the creation of decentralized finance or DeFi. The aforementioned feature provides users with decentralized methods for asset management. These services, which are led by decentralized exchanges, are supported by fundamental technologies. Liquidity pool is one of the most popular and attractive technologies that help decentralized transactions a lot.
Liquidity pools in decentralized exchanges actually replace orders that are registered in the order book of centralized exchanges. The mechanism of centralized exchanges such as Binance and Coinbase is based on an order book that records all buy and sell orders and when the sell order matches the buy order, it performs the asset exchange. In this case, the centralized exchange monitors all transactions, and the authentication and determination of the nature of users is also of particular importance for them.
The issue of authentication of users is not the issue of decentralized exchanges. At the same time, instead of using the order book, these exchanges take the help of an automatic market maker (AMM) to provide the assets needed by traders through liquidity pools without the supervision of a third party. All this process is done without the need for central institutional supervision; Hence, it is obvious that decentralized exchanges are more powerfully moving in the direction of blockchain’s core idea and philosophy of decentralization.
Read more: What is an Automated Market Maker (AMM)?
The liquidity pool is the basis of many DeFi applications, including lending protocols, yield farming, on-chain insurance services, and blockchain games. Now the question arises, what is the liquidity pool and how can it work automatically and without the need for central supervision? Follow us to the end of this article to find the answer to this question.
What is Liquidity Pool?
A liquidity pool is a collection of digital currencies or tokens that are locked in a smart contract and used to facilitate the process of transactions and transactions in a decentralized exchange. Simply put, you can think of a liquidity pool as a large digital pool where everyone can deposit their digital assets without the need for permission or permission, and at the same time, borrow certain amounts from this financial source.
Cryptocurrency liquidity pools play an essential role in the decentralized finance ecosystem; Especially when it comes to decentralized exchanges. A liquidity pool is a mechanism by which users can pool their assets in smart contracts of decentralized exchanges to provide necessary liquidity to traders. Liquidity pools can be seen as smoothing the speed and convenience of transactions in the DeFi ecosystem; Two important features that this ecosystem desperately needs.
Before liquidity pools and automated market makers came into play, cryptocurrency market liquidity was a serious issue for exchanges and decentralized trading platforms. At the time, decentralized exchanges were an emerging technology with complex user interfaces that attracted few buyers and sellers. As a result, it was difficult to find many traders and enough liquidity to conduct frequent transactions in these exchanges.
The entry of the liquidity pool into this scene created an astonishing evolution in providing liquidity and attracting traders to decentralized exchanges. Liquidity pools provide the necessary resources for transactions without the need for third-party intermediaries. The more liquid the assets are in the pool, the easier it is to trade on that decentralized platform.
Read more: 3 Big Threats in DeFi Lending Platforms
How does the liquidity pool work?
As we mentioned, liquidity pools are based on smart contracts; Therefore, all users of liquidity pools deal with smart contracts and cryptographic algorithms instead of individual individuals. So if you are a buyer, you don’t need a specific seller; It is enough that the liquidity pool of the platform you use has enough liquidity. If you are a seller, cryptographic algorithms do the work of selling your property.
In this situation, everything from user activity to asset pricing is handled using smart contracts. These smart contracts are designed to incentivize liquidity providers to contribute their assets to the pool by offering rewards and transaction fees.
Users who participate in funding liquidity pools are rewarded with liquidity tokens for their contribution. These tokens are often valuable assets that can be used on other platforms in the DeFi ecosystem. As long as the user’s asset is locked in the pool, he can benefit from the commission profit proportional to his capital; But when the liquidity provider wants to withdraw its principal from the pool, it must burn its liquidity tokens.
Liquidity pools often consist of two digital currencies or currency pairs, which are deposited in the pool in an equal ratio of fifty-fifty. Algorithms of smart contracts ensure that this ratio is maintained throughout the lifetime of the pool, regardless of whether supply and demand increase or decrease. Liquidity providers also help maintain a constant supply rate of the pool currency pair by providing an equal amount of both tokens. Providing sufficient liquidity helps to stabilize prices and prevent manipulation of asset values.
Also read: The most comprehensive DiFi training; From Garlic to Onion of Decentralized Platforms
Liquidity pools and interest cultivation
Different protocols are trying to improve the trading experience of their platforms to increase the incentive of liquidity providers to participate more. As we mentioned, offering rewards and incentives such as valuable cash tokens can attract more suppliers to the pool. In this case, we can also consider liquidity providers as liquidity extractors.
Cash mining is the process of adding digital assets to cash pools in DeFi protocols, usually with a reward in the form of cash tokens. Now, how is the value of these liquidity tokens provided and what are the uses of these tokens?
Here, a process called Yield Farming comes into play. Profit cultivation helps the user to increase his profit and passive income. In profit farming, liquidity providers lock their liquidity tokens in various blockchain protocols and receive profit in return. Many DeFi marketplaces and platforms and incentive pools allow providers to create value with their liquidity tokens as well.
In this case, the providers of the liquidity pool with a little more risk, in addition to the profit from investing in the pool, also receive profit from their liquidity tokens. A number of platforms, such as Yearn.Finance, allow their users to use automatic risk and return selection to get the desired profit from investing their assets in different platforms.
Also Read: Which DeFi Sectors Have Good Investment Opportunities?
Conclusion
In this article, we briefly introduced you to the liquidity pool and its principles, and pointed out how liquidity pools work and what place these pools have in the development of decentralized finance. Also, we mentioned important points related to how to get double profit from investing in liquidity pools and profit cultivation platforms.
Even though you are familiar with the general principles of this investment tool, you should note that providing liquidity and cultivating profit cannot be a suitable strategy for all traders. Investing in liquidity pools is associated with risks. For example, if your investment property in a pool declines in value during the lock-in period, you have suffered a loss.
Therefore, before any investment, do enough research and know all the pros and cons of different investment strategies. If you are fully familiar with the liquidity extraction mechanism, you can make significant profits and increase the liquidity of your investment portfolio.