The financial system relies heavily on liquidity. It is the financial market's backbone, and without it, the entire financial system would be unable to function. Liquidity is crucial because it has a considerable impact on asset values. Simply put, liquidity refers to the ability to purchase and sell assets in the market without generating significant price changes.
Traditionally, liquidity is provided by a central organization, such as a bank or accredited financial institution. For example, the US dollar is considered the most liquid asset because it can be exchanged for almost anything at the item's actual value. So basically, you can buy whatever you want, anytime you want.
Similarly, the central authority who serves as custodian provides liquidity on centralized exchanges (CEX) or the CeFi. This means that liquidity is critical when executing trades without significantly affecting asset prices.
Unlike CeFi, which functions on the premise of central authority, DeFi allows complete decentralized trading by completing trades on-chain using a unique model called a liquidity pool.
What is a Liquidity Pool?
A liquidity pool is a supply of funds locked in a smart contract and used to facilitate decentralized trading, lending, and other activities. For example, users can use liquidity pools to buy and sell crypto on decentralized exchanges (DEX) and other DeFi platforms without relying on centralized market makers.
The concept of a liquidity pool is simple. Liquidity pools enable transactions between individuals without the involvement of a trusted third party, and it plays an essential role in the DeFi ecosystem, such as automated market makers (AMM), borrow-lend protocols, yield farming, and synthetic assets, on-chain insurance, and blockchain gaming.
Interestingly, a user known as Liquidity Provider (LP) earns rewards by providing liquidity to a pool to form a market. As a result, LPs earn transaction fees on trades in their pool in proportion to their share of total liquidity for providing their funds.
How does a Liquidity Pool Work?
The Order Book approach is used for trading on centralized cryptocurrency exchanges, where buyers and sellers issue orders. While buyers want the lowest possible price for an asset, sellers seek the highest possible price for it. Therefore, both the buyer and seller must agree on the price for the transaction to take place.
However, an improved method to the order book model is the introduction of the Automated Market Maker (AMM). AMM is the smart contract that facilitates the price adjustment of trades. Because they are decentralized, they allow buyers and sellers to trade directly with one another instead of relying on a central market maker to match them through the order book method.
Unlike centralized peer-to-peer, AMMs provide greater flexibility for trading in token pairs as; they allow on-chain trading to be carried out by focusing on the interaction between peers and contracts. There is no buyer at the other end of the trade, only a smart contract algorithm. So, for example, in the case of peer-to-peer (P2P) trading, where a buyer trades with a seller, you have peer-to-contract trading (P2C), where the buyer/seller trades with a smart contract.
Conversely, a liquidity pool contains at least two different tokens in an equal ratio in the smart contract. So, for example, if you want to add $1000 of your asset into a liquidity pool, you need it in pairs, say ETH/DAI. This is because you'll need an equal amount of ETH and DAI ($500 each) to be deposited into the pool. If someone wants to trade ETH for DAI, they can do so using the funds invested in the pool.
This model differs from typical exchanges because it does not rely on orders. As a result, the underlying smart contract will automatically deliver a percentage of transaction fees paid by users who utilize the pool to swap tokens "LP token" to the LPs in proportion to their stake size.
Benefits of Liquidity Pool
Decentralization and Anonymity
Because there is no registration process and no KYC, liquidity pools guarantee anonymity to their users. As a result, anyone can provide liquidity to the pool. It is also entirely decentralized, as there is no global authority, only an AMM smart contract operation.
High ROI
Liquidity pools let you become a market maker and participate in various DeFi protocols while benefiting from high returns typically more profitable than hodling.
Passive Income
By deploying their LP tokens on various DeFi protocols, liquidity providers gain access to several layers of income opportunities without having to trade their tokens and have control of their tokens.
Risk Associated With Liquidity Pool
Impermanent Loss
The AMMs do not adjust token prices in response to market fluctuations. For example, if the price of an asset falls by 40% on a price chart, the move will not be reflected instantly on a DEX. When the ratio of two assets kept in a liquidity pool becomes unequal because of the sudden price fluctuation in one of the assets, LPs may suffer impermanent loss. However, if the fund is withdrawn from the pool before the market recovers, the LP may experience permanent loss.
Smart Contract Risk
Smart contracts are paperless digital codes that contain parties' agreement on established rules that self-execute. As a result, liquidity pool smart contracts may include bugs or be vulnerable to hackers if the underlying code is not securely audited, putting your token at risk.
Developer's Access
In some projects, the developers have the authority to change the pool's regulations. For example, developers may have an admin key or other privileged access within the smart contract code. This gives them the ability to potentially do something harmful, such as taking control of the pool's assets.
Final Takeaway
Liquidity pools are critical to the expanding and increasing interest in the DeFi sector. As a result, its development presents a new strategy to improve decentralized finance by eliminating the need for a central authority.
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