We’ve seen how PoS and PoW help remove the middleman from payment transactions. But Decentralised Finance (Defi) also gives rise to Liquidity Pools and Yield Farming. These powerful projects have given rise to peer-to-peer lending, borrowing and made decentralized exchanges a reality.

Let’s see what these terms are.

Liquidity Pools

Think of stock market brokers like Robinhood. They are centralized and have a clearing house responsible for settling trading accounts between the buyer and seller.

A liquidity pool is like a decentralized exchange that consists of pairs of tokens locked in a smart contract.

To put it simply, you need to lend two assets to the pool and in return, you’d get a Liquidity Provider token and trading fees for any lending, borrowing, or trading that occurs on your pair of tokens.

The whole goal of liquidity pools is to facilitate trading.

Yield Farming

The LP token that you receive from pools acts as governance tokens. This means you hold voting rights on changes happening in that pool.

But more importantly, you can further leverage those liquidity provider tokens by staking them in other pools to earn even bigger rewards.

While yield farming and liquid pools do involve staking, both of these actually don’t force you to lock your funds. Unlike staking which is done to validate a network, yield farming is like swing trading with the sole goal to chase maximum returns on LP tokens.

But wait… doesn’t liquidity pools and yield farming seem too good to be true?

Yes, despite the high returns you could reap from these DeFi projects, liquidity pools are the riskiest form of investment in cryptocurrency today.

It’s worth knowing that liquidity pools require maintaining a strict ratio of both the coins/tokens.

Consider an example, of a liquidity pool that accepts a 50: 50 ratio. Now, one of the token’s prices could swing up or down a lot more than the other. Or some trader could swap them using a DEX in a way that skews their ratio.

In such cases, the pool will need to rebalance the number of coins so that the initial ratio is maintained. This could put you at a loss when you eventually withdraw your coins.

Essentially, DeFi gives us the ability to be our own banks such that you can lend and borrow cryptocurrencies and also provide liquidity to exchanges. However, there’s always a chance of an impermanent loss — a term that indicates a loss of the initial investment due to volatility.

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Source: https://themakingofamillionaire.com/6-cryptocurrency-buzzwords-you-should-know-before-investing-95f76187cb0d?source=rss——-8—————–cryptocurrency