Zephyrnet Logo

Defi Concepts: What Is Liquidity Pool & How Does It Work?

Date:

When any Liquidity pool is created, LP(liquidity provider) decides the initial base price and sets the equal supply of crypto-asset pairs. This rule of equal supply applies to all other LPs willing to provide liquidity to the pool.

It is imperative to understand that any trade being executed by traders using AMMs is not controlled by any counterpart, Instead, you’re executing the trade against the liquidity in the liquidity pool. So if you desire to buy the coin, you are not required to have any real seller to do so, you only need to engage with the Liquidity pool, which in turn is governed by smart contracts to ensure sufficient liquidity, to facilitate your buy trade request.

Smart contracts also do the price discovery using the algorithm which is based on the trades that happen in the liquid pool. But you must be wondering why does someone want to supply their assets owned in their wallet and risk the same.

Well, the answer lies in the incentive programs provided by Defi exchanges. As LP you are rewarded in proportion to the amount of liquidity you supply to the Liquidity Pool. For every successful trade which happens in the pool you have contributed, you get the transaction fee that is proportionally distributed among all Liquidity Providers supported by the concerned AMMs

The proportions of the tokens lying in the Liquidity Pool controls the price of assets in consideration. For example, when you buy ETH from the DAI/ETH pool, the supply of ETH is reduced from the pool, and the supply of DAI is increased proportionally. This will increase the price of ETH and decrease the price of DAI.

We have earlier touched upon some of the use cases of the Liquidity pools, now it’s time to capture some of the popular ways in which Liquidity pool helps in functioning DEXs.

We have already discussed AMM which is one of the core use cases of liquidity pools, apart from this they are many more concepts like

Liquidity Mining :

Liquidity mining has been the popular way for crypto investors or traders to put their crypto to work, in earning passive income. Liquidity mining is also popularly termed as Yield Farming.

Liquidity pools concepts are utilized by platforms like Compound or Yearn finance, which makes use of automated yield generation against the pooled assets and pays the reward to LPs as a yield. Using liquidity mining this yield or newly minted tokens are distributed proportionally to each user based on their share of the pool.

To learn more about yield farming please read my article below

To facilitate Project or Governance:

There are many projects or situations where voting via token is required and the counts need sufficient supply for the same, to build some consensus for pushing forward a strong governance proposal. Liquidity pool concepts can be used here to pool the sufficient funds from participating users and enforce some kind of strong governance required for any Defi protocols to sustain or thrive.

Generating Synthetic Tokens :

Liquidity pools are also required to mint synthetic tokens. In order to generate such tokens on the need to provide some crypto assets as collateral on liquidity pool, which in turn connects to the trusted blockchain oracle.

Blockchain oracles are third-party services that provide smart contracts with external information. They serve as bridges between blockchains and the outside world.

to award you the desired synthetic token that’s pegged to whatever asset you’d have pooled as collateral.

Apart from all the above, there are many use cases in decentralized insurance, voting, etc…which we will discuss in detail in some other articles.

As discussed, Liquid pools have multiple advantages like Providing Constant liquidity at fluctuating price levels, Automated & fast price discovery, AMMs, etc. But it has its own limitations which need to be factored by every trader looking to take advantage of this concept.

One such risk is termed as:

Impermanent Loss :

One needs to understand this risk factor of impermanent loss, before jumping into the use case of liquidity pools. This is the loss where the original price of your pooled token can nosedive. leading to extreme loss.

Here the loss means less dollar/fiat value at the time of withdrawal than what it was at the time of pooling. This phenomenon arises when the price ratio of assets in a liquidity pool changes drastically

Yes, it means that there is a potential risk of losing all your pooled funds permanently due to some issues with AMM/s smart contract bugs or some kind of manipulation in Liquidity pools. This loss can be irrevocable and needs to be factored in by every trader.

Can this be mitigated?

Yes, there is some possibility. As long as you do not withdraw deposited tokens at a time that the pool is experiencing a change in price ratio, it is still possible to mitigate this loss. Often this loss can be curtailed if the prices of the tokens revert back to the original value. So if you are patient enough & strong-headed, you can still give yourself a chance to bounce back, else if you panic and decide to withdraw you may end up losing the token value permanently

Fortune comes to those who have the courage to suffer the pain when things look difficult, so if you are new to this Defi world & don’t have sufficient education regarding the concepts associated with it, you need to invest some time understanding all the nuances associated with your favorite crypto projects.

With the high level of awareness and calculated risk, you may definitely take advantage of Liquidity pools, liquid mining to earn some decent income apart from trading on centralized crypto exchanges.

If you have the patience to stay invested for long and to use the popular tools like Dollar cost average , Yield farming , crypto staking as a seeker you can’t go wrong.

PlatoAi. Web3 Reimagined. Data Intelligence Amplified.

Click here to access.

Source: https://medium.com/crypto-wisdom/defi-concepts-what-is-liquidity-pool-how-does-it-work-3b8f6119430a?source=rss——-8—————–cryptocurrency

spot_img

Latest Intelligence

spot_img