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Liquidity Pool

Not too long ago, the global financial market was a cauldron of tedious paper works and time-consuming exchanges, plus unnecessary bulky charges, due to the centralization from bank and stock exchange markets which were the fulcrum of most transactions. Above all, there was no accountability for any misconstruction within the governance processes, because not only did the traders lose custodial power over their assets, there were sometimes problems of price hikes and lack of public transaction ledgers. To cancel out these barricades of risks, the unmistakable need to decentralize the world of finance surfaced.

Decentralized finance (DeFi) has peaked over the years, bringing a staggeringly spiking on-chain activity on its protocol. As of 2021, around $15 billion was stapled to have been locked in decentralized finance protocols, and is still predicted to skyrocket by the following year. And it’s already happening now quite glaringly, if we acknowledge the rapid turn-out of new innovative platforms storming the global market. Surprisingly, the centralized and decentralized exchanges are both on the same growth ladder.

In lieu of the notable DeFi growth, there’s an important concept that makes it all possible — the liquidity pool. This concept has led innovations within the DeFi ecosystem, ploughing through decentralized exchanges, borrow-lend operational system, yield farming, on-chain insurance, to name but a few.

Worthy of note: it’s not that centralized protocols like banks do not offer liquidity but, in some way, there are a wide range of limitations that makes them utterly unreliable.

The Unobjectionable Necessity of Liquidity Pools

Liquidity pools can be simply explained as a box of cryptocurrency assets or tokens kept in a smart contract as a tool to facilitate trade on a decentralized protocol. Little or no liquidity, any trader will acknowledge, creates grievous negations while entering and exiting the market — such as high-scale spillage and volatility. Liquidity pools strive towards ensuring that users can distribute their tokens or assets through smart contracts in a decentralized exchange to generate liquidity assets for traders without facing any inconvenience as regards speed or usability.

Before the coming of Automated Market Makers (AMM), most market order prices suffered from depreciating volume and high volatility because transactions were done through centralized order books-based model. This means that there were quite a small number of buyers and users which makes it utterly hard to find potential traders. This was a major problem in decentralized finance. But AMMs came with a fix for the qualm by providing a ground for creation of liquidity pools, and as well as accosting incentives to liquidity providers to supply pools with assets without the interference of third-party souvenirs, and even make income in the process. More like: The higher assets existing in a pool, the higher the liquidity the pool inhabits, and consequently the more convenient and easier trading becomes within the decentralized exchanges. This is to say that users within liquidity pool protocols like Bancor, Uniswap or CrossFi can exchange their assets through smart contracts without having to wait for a matching pair.

Workability of Liquidity Pools

Liquidity pools are built on automated market makers, which has directly and indirectly driven a change in the mainstream on-chain procedures for trading cryptocurrencies.

Since order books are not being used, users can easily enter and exit the protocol with trading pairs, and without losing their custodial authority. Whereas order books-based protocols allow peer-to-peer exchange for traders which take more time and causes price spillage, AMMs creates a peer-to-contract model for traders to carry out their transaction, which means that buyers do not have to wait for a matching pair because there’s sufficient liquidity and trades are overseen by algorithms which pull together data and information from multiple trading platforms to ensure a better pricing.

The most important thing about liquidity pools is how it gives everyone leverage to become a Liquidity Provider (LP). Liquidity providers are those that supply assets and tokens to generate a liquidity pool to be used in the supposed decentralized finance protocol.

Liquidity Pairing Pools As a Generator of Income

There’s no denying the fact that many users are trooping into liquidity pools. As of 2021, Uniswap, one of the most popular DEXes, has almost $250 million locked in it. Even Sushiswap, the virtual sister of Uniswap, is on the same crest. To some extent, such increasing users is as a result of the expanse of benefits they accord their users. One of such importance is hinged on the basis of financial interest, and we’ll be looking briefly into them.

Liquidity Mining or Yield Farming

As established before, the generation of a larger liquidity can be actualized through providing many incentives for users to deposit more tokens to incentivized pools, which in turn helps to facilitate a better trading experience. The process by which a user offers assets and tokens in these pools to create sufficient liquidity to earn a certain amount of LP rewards or LP tokens is known as liquidity mining. This can also include a mechanism through which users can stake their assets within a blockchain based provider to maximize tokenized rewards, thereby increasing a liquidity provider’s yearly earnings. This shares a bit of similarity with a savings account where one can deposit and collect interests after some time. The yield of a user might vary across different platforms (such as Yearn, CrossFi etc.) depending on the incentivized pool, potentiality of the protocol, the overall market value of the cryptocurrency being deposited.

Asset or Token Distribution

This is another productive aspect of liquidity mining. The distribution of tokens to users who have provided their tokens or assets to the pool is regulated by algorithmic computation, thereby leading to an efficiently better trading space. Such tokens might even come from a different liquidity pool. That means that a user who engages in the borrow-lend protocol of CrossFi or just the Compound’s lending suppositories would surely get their interest and shares, and as well have the opportunity to share the given tokens in another pool for substantial rewards.

A Closing Remark

Even though liquidity pools face a problem of impermanent loss and smart contracts issues, no one can dispute that they remain the mitochondrion of the current DeFi ecosystem, enabling decentralized exchange, lending, yield acquisition and so on. The end product is movement, a philosopher once quipped. And we ought to keep flitting through the magic flowers of liquidity pools, and constantly marking their significant functionalities.

CrossFi is a cross-chain protocol that provides liquidity to you for Filecoin staking and rewards.

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