What Are Crypto Liquidity Pools
How Liquidity Pools Are Important In DeFi
Today, we’ll look over the Crypto Liquidity Pools. What are the Crypto Liquidity Pools and how they are important in Decentralized Finance (DeFi).
Liquidity pools play a large part in creating a liquid decentralized finance (DeFi) system. Liquidity pools are one of the foundational technologies behind the current DeFi ecosystem. They are an essential part of automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, blockchain gaming and so on.
Liquidity pools help keep things running smoothly in decentralized finance (DeFi). Without liquidity, financial systems grind to a halt.
Let me explain what decentralised finance is. If you’re new to blockchain, it will help you to understand Liquidity pools better.
What Is Decentralized Finance (DeFi)
Decentralized finance is a system powered by blockchain and cryptocurrency technology, forming an alternative to the traditional financial system. DeFi creates a financial system that is creative, open, global, and transparent. It offers financial products to users without intermediaries like banks and exchanges.
Aave (AAVE), built on Ethereum protocol and formerly known as ETHLend, is one of the first and biggest DeFi platforms.
Now let’s move further…
What Is Liquidity
Liquidity is a fundamental part of both the crypto and financial markets. It is the manner in which assets are converted to cash quickly and efficiently, avoiding drastic price swings. If an asset is non-liquid, it takes a long time before it is converted to cash. You could also face slippage, which is the difference in the price you wanted to sell an asset for vs. the price it actually sold for.
Example Of Liquidity
Imagine waiting to order inside a fast-food restaurant. Liquidity is comparable to having lots of cashiers. That would speed up orders and transactions, making customers happy. On the other hand, non-liquidity is comparable to having only one cashier with a long line of customers. That would lead to slower orders and slower transactions, creating unhappy customers.
What Are Liquidity Pools
Liquidity pools refer to a collection of tokens or digital assets locked in a smart contract that provide essential liquidity to decentralized exchanges.
DeFi activities such as lending, borrowing, or token-swapping rely on smart contracts — pieces of self-executing codes. Users of DeFi protocols “lock” crypto assets into these contracts, called liquidity pools, so others can use them.
Traders, often called Liquidity Providers (LPs), contribute to liquidity pools. They do so by using a decentralized exchange (DEX) platform. One popular example is the DEX Uniswap and the blockchain Ethereum. Liquidity pools exist within a DEX, and all trades of asset pairs go through them.
DeFi relies on liquidity pools to function. A decentralized exchange (DEX) without liquidity is equivalent to a plant without water. It won’t survive. Liquidity pools provide a lifeline to DEXs.
How Do Crypto Liquidity Pools Work
A liquidity pool is a smart contract where tokens are locked for the purpose of providing liquidity. Some of the important concepts required to understand how liquidity pools and decentralised exchanges work include liquidity providers, liquidity tokens and automated market makers.
Liquidity pools are used not only by decentralised exchanges to swap tokens, but also for borrowing and lending activities. As such, they play an important role in the DeFi ecosystem.
A liquidity pool consists of 2 cryptocurrencies or tokens. Pools create different markets for a pair of tokens. The originator of each new pool sets the starting price for that asset. But if that price for the pool is not in line with the global crypto marketplace, the liquidity provider can lose its capital. Keeping tokens in line with market prices as more providers add funds to the pool is important.
As the liquidity pool facilitates token swaps, the price will adjust based on a pricing algorithm. Each liquidity pool might use its own algorithm to calculate the value. The algorithm ensures that the pool always has liquidity no matter the size of a trade. These are frequently called Automated Market Makers (AMMs).
The token ratio governs the pool’s price. For example, in the DAI/ETH pool, if someone buys DAI from the pool, that increases the volume of ETH, which increases the price of DAI and decreases the price of ETH. The total change in price will vary based on how much the person bought and how much it changed the pool. Larger pools see fewer fluctuations because it takes very large trades and purchases for changes to occur.
The liquidity providers earn money from the transaction fees for others to buy and sell from the pool. Those transaction fees go back into the liquidity pool to further increase the value of your tokens and aid in growing the pool.
Established liquidity pools can have well over $1 million invested, which makes them fairly stable for new traders looking to get started with crypto. Smaller pools can be more susceptible to fluctuations in the market, which can mean that the value of your tokens decreases. With the right pool, you can enjoy excellent value stability while earning transaction fees to increase your original investment.
Comparing The Working Of An Order Book & A Liquidity Pool
The importance of liquidity pools is better understood when we compare them with traditional order books.
The order book is a digital list of crypto buy and sell orders arranged by price levels and updated continuously in real-time. In simple terms, buyers and sellers submit orders for the number of tokens they want to trade and at what price. The method requires that someone else be willing to meet the order. Otherwise, traders would transact at an unfavourable price or wait for a long time to see someone who meets their desired price.
Liquidity pools ensure that buy and sell orders are carried out no matter the time of the day and at whatever price you want to trade without looking for any direct counterparty. The system uses an Automated Market Maker (AMM) to ensure this. You won’t need to find a seller to buy a token. All that is needed is sufficient liquidity in the pool.
When a token swap occurs, the AMM ensures that the price adjusts based on its algorithm. The algorithm ensures that there is always liquidity in the pool, no matter the trade size.
A liquidity pool is, by default, a 50:50 ratio of 2 coins. Let’s say 50% bitcoin (BTC) and 50% ether (ETH). When you buy BTC with ETH, the pools will start to lose BTC and get more ETH. The algorithm increases the price of bitcoin and lowers the price of ether to keep the ratio regulated. The process is a self-regulated automated reaction to the market’s needs.
How Do Liquidity Pools Make Money
When an investor supplies liquidity to a pool, that individual makes money by allowing others to use that liquidity for transactions. The investor supplying the liquidity earns a percentage of every trade.
Advantages of a Crypto Liquidity Pool
A liquidity crypto pool has many great advantages for managers, investors and traders. These advantages can include the following.
- Ensures there is enough liquidity to meet DeFi protocols
- Anyone can provide liquidity to these pools
- Provides many layers of earning potential
- Earning a governance token can provide voting rights to oversee decision-making concerning the pool
- Users maintain control of their digital assets
Best Liquidity Pools
The best liquidity pools are those that are large enough to limit risks and large fluctuations, have a long history, good daily volume, and large reserves. Some of the best liquidity pools are BTC/USDT, DAI/USDC/USDT, renBTC/WBTC, renBTC/WBTC/sBTC, HBTC/WBTC, WETH/USDT, USDC/WETH.
How Can You Add Liquidity
Broadly, there are two ways of adding liquidity.
If you want to add funds directly to a liquidity pool, such as the ETH/USDC liquidity pool on SushiSwap, you will need to have equal amounts of ETH and USDC, which you can swap using any decentralized exchange.
You generally need an equal pair of tokens because trading, borrowing, and most other DeFi activities are almost always two-sided — you exchange ETH for USDC, you borrow DAI against ETH, and so on. As a result, most protocols require liquidity providers to pledge the equivalent value (50/50) of two crypto assets to available pools so that a balanced pair can be maintained. The Balancer has taken an innovative approach, allowing as many as eight tokens in a liquidity pool.
Top Crypto Liquidity Pool Entries For 2022
There are the top crypto liquidity pools entries for 2022
Uniswap
The open-source exchange can help any individual in launching new liquidity pools for any token without any fees. Uniswap as one of the best liquidity pools refers to the exchanging fee of 0.3%. Liquidity providers get a share in the exchanging fees, according to their share in the liquidity pool. When you offer liquidity to the platform, all you have to do is deposit crypto assets in return for the Uniswap token.
Balancer
The top crypto liquidity pools list would obviously refer to Balancer. Users enjoy the flexibility of customizing pools alongside earning trading fees by subtracting or adding liquidity. The modular pooling protocol of Balancer serves as its foremost strength. It provides support for multiple pooling options, including private, smart, or shared pools.
Crypto Liquidity Pools Are Essential To DeFi
Crypto liquidity pools are essential parts of the Decentralised Finance (DeFi) ecosystem, especially for Decentralised Exchanges (DEXs). Crypto liquidity pools allow users to pool their assets in a DEX’s smart contracts to offer asset liquidity for traders to swap currencies. As a result, liquidity pools provide much-needed liquidity, rapidity, and convenience to the DeFi ecosystem.
Crypto market liquidity was a barrier for Ethereum-based DEXs before the arrival of automated market makers (AMMs). At the time, DEXs were a new technology with a complex interface. The number of buyers and sellers was limited, making it challenging to locate enough individuals willing to trade daily. Without the need for third-party intermediaries, AMMs address the issue of low liquidity by building liquidity pools and rewarding liquidity providers to provide assets to these pools. The more convenient it is to trade on Decentralized Exchanges (DEXs), the more assets and liquidity a pool has.
Wrap Up
This article included a discussion on liquidity pools. What are liquidity pools and how liquidity pools are important in DeFi. Liquidity pools are one of the core technologies behind the current DeFi technology stack. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power almost every part of DeFi, and they will most likely continue to do so.
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