What Are Liquidity Pools?

Without liquidity, modern financial systems couldn’t operate. In decentralized finance (DeFi), the concept of liquidity has been implemented in the form of pools. So what are liquidity pools? How do they work? And how do they relate to Decentralized Finance (DeFi)?

This article will provide you with answers to these questions in the simplest terms.

What is a liquidity pool?

A liquidity pool is a vault into which market participants pool their assets for the purpose of collectively providing an extensive supply of liquidity for anyone intending to exchange assets. In a traditional financial system, large banks act as the pool. They manage the funds of different depositors and can even “print” additional money.

A liquidity pool in cryptocurrency is the stock of tokens locked on a particular smart contract account. They are used to support trading activity (trading) and are heavily relied on by decentralized exchanges (DEXs).

One of the first projects that introduced the concept of a liquidity pool was the Bancor project. However, it was the Uniswap project that brought the concept of the liquidity pool to prominence.

How do liquidity pools work?

In its basic form, a liquidity pool contains two tokens, thus creating a new exchange market for these assets.

When a new pool is created, the first liquidity provider sets the starting exchange rate for assets within the pool. Each provider must deposit an equal number of both tokens into the pool. Suppose the starting exchange rate within a pool differs from the current global prices. In that case, this immediately creates an arbitrage opportunity that could result in the loss of capital for the liquidity provider. This concept of supplying tokens in the correct ratio remains valid for all subsequent providers who wish to lock their funds in a pool.

After sending tokens to a pool, the provider receives unique tokens (LP tokens) — in proportion to how much liquidity they provided. When a transaction that uses one such pool occurs, the decentralized exchange charges a commission of 0.3% of the transaction. It distributes this commission among every participant in the pool in proportion to their share. Thus, there is an income due per the provision of liquidity. If the provider wants to return the invested funds from the pool (including accrued income), they must burn their LP tokens.

Each exchange of tokens, which takes place with the help of a liquidity pool, leads to the exchange rate moving in accordance with a special algorithm. This mechanism is called Automatic Market Maker (AMM), and liquidity pools of different protocols may use slightly different algorithms.

Basic liquidity pools like Uniswap use a constant that is calculated as the product of the amount of both tokens in the pool. Thus, the pool can always provide liquidity. To put it simply, the fewer A tokens there are, the more expensive they become, and the cheaper B tokens become. It turns out that if someone buys a lot of ETH in the ETH / DAI pair, they reduce the supply of ETH and increase the supply of DAI, which is immediately reflected in the course of exchange. The larger the volume of the pool in relation to the size of the transaction, the less this transaction affects the price.

Large pools of liquidity create a more stable environment where each trade has little effect on the exchange rate movement. This is the ultimate goal of market participants and liquidity providers (recall, they earn commissions from transactions, thus more transactions result in more income). This is why protocols like Balancer have begun to encourage liquidity providers to invest their tokens in certain small pools in order to “swing” them. This process is called liquidity mining.

What are liquidity pools used for?

If you are already familiar with crypto exchanges such as Binance or CEX.io, you are probably aware that trading activity is carried out using an order book.

Buyers want to buy an asset at the lowest possible price. Sellers, in turn, would like to sell at the highest possible price. For transactions to occur, buyers and sellers must agree on a “fair price.” As a result, either the buyer is ready to pay more, or the seller agrees to sell for less.

But what happens if neither of the market participants is ready to change their expectations? Or if there are not enough tokens to satisfy an order? At this point, market makers come into play.

Market makers are larger players who support trading activity with their readiness to buy or sell any amount for a given asset (“any” — meaning large enough for most players). Of course, their “fair price” is always slightly biased in their favor. They work similarly to an exchange office: due to the “spread” between the buying and selling rates. Thanks to the existence of market makers, you don’t have to wait for a seller to show up for the asset you want to buy; the same is true in reverse.

The main problem is that the order book model relies heavily on having a market maker (or multiple) for each asset. Without market makers, the exchange immediately becomes illiquid and inconvenient for ordinary users. None of us are accustomed to waiting hours just for the possibility of making an exchange. In addition, market makers constantly change their exchange rates by creating and closing orders in the ledger. Supporting this type of activity would lead to heavier traffic loads on a blockchain, for which end users would pay a higher fee. Again, everything would be slower. For example, the Ethereum blockchain, with its current throughput of 12–15 transactions per second, simply could not support such a model.

The problem with the order book model has long been a concern in cryptocurrency. On the one hand, this has led to the development of alternative, faster blockchains like EOS. On the other hand, projects like LoopSpring are planning to build a layer two infrastructure for Ethereum.

So far, the most successful concept has been to abandon the order book altogether. This is what gave birth to decentralized liquidity pools.

What is crypto liquidity pool farming?

Liquidity farming is a concept in decentralized finance (DeFi) that involves placing cryptocurrency assets into a liquidity pool in order to obtain more cryptocurrency in the form of interest. The smart contract manages the liquidity pool, and the users who deposit or stake in cryptocurrencies are called liquidity providers (LPs).

Liquidity farming works like a regular investment where you invest in a platform to earn money over time. However, in this case, you use digital assets or currencies rather than traditional currencies. As a result, the returns you receive from your cryptocurrency liquidity are higher than what you would normally receive from a savings account.

In conclusion

TheStandard.io offers users the opportunity to generate strong returns through the purchase of liquidity bonds. These bonds are purchased using your newly minted sEURO paired with USDC and pay out the initial value, plus returns, via the native governance token, The Standard Token (TST). These unique high-yielding bonds are easily acquired and redeemed through TheStandard.io’s user interface or by interacting directly with the smart contracts on the blockchain.

The Standard allows you to mint your first stablecoins at a discount, earn quick yields for helping to build a secure protocol, and provide liquidity for the protocol’s first stablecoin, the sEURO.

Add your sEURO to the protocol liquidity pool to start earning a generous yield.

How to get involved

Don’t miss our initial minting event and mint sEURO to get instant yields.

Visit https://app.thestandard.io now to get started!

For those who have already received your TST rewards from stage 2, you can now stake your TST for sEURO now in stage 3 of our Initial Minting Event! Head to https://app.thestandard.io/stage3 to get started.

Check out thestandard.io for more details on how the IBCO works and instructions to do so.

Finally, join our community on Discord for any questions or support you need with the project! https://discord.gg/thestandard-io-836907456743079956