Why Liquidity Pools are important in DeFi

👨🏫 Article from the section "Education"

Decentralized finance (DeFi) is becoming more and more popular. The reason for this is certainly the popularity of decentralized platforms (DEXes). Today, they fully compete with their centralized counterparts in terms of volume. In 2020, more than $15 billion was locked in DeFi protocols. And, new types of products are emerging, only increasing this enthusiasm for DeFi.

And at the heart of these many applications and protocols are “liquidity pools.”

This is certainly one of the major concepts in the DeFi ecosystem. Liquidity pools are essential as they are what allow many protocols to exist and operate.

We find liquidity pools in different protocols in fact, such as automated markets (AMM), the famous lending protocols (borrowing/lending on DeFi, the Yield farming, insurance protocols, certain gaming protocols, etc.).

In short, liquidity pools are everywhere in DeFi and without them, we would not be able to “run” the protocols.

The concept is simple to understand.

This is what we will see here, don't panic, if it is not yet very clear.

What is a liquidity pool?

A decentralized platform (DEX) like Uniswap for example works with Liquidity Pools. These liquidity pools represent a set of assets. It is because there are liquidity pools that there can be exchanges on these platforms. They guarantee the operability of DEXs.

These liquidity pools do not finance themselves. Those are the liquidity providers (LP/Liquidity Provider) which will in fact finance these pools. They will deposit funds. More precisely, they will deposit an equal value of two different tokens of a pair. For example, a liquidity provider will deposit $1000 in ETH and $1000 in DAI. Thus, by financing this pool, it will allow users of the platform to actually be able to trade with the ETH/DAI pair, for example.

In exchange for this funding, the liquidity providers will receive rewards. These rewards are fees from transactions that occur in their pool. The amount of the reward is proportional to the total liquidity share.

So, as one can understand, the fact that everyone can be a liquidity provider and with such an incentive, decentralized platforms can therefore function properly.

Several protocols have been launched and we can cite Bancor which was one of the first to do so. That said, the one who really popularized this type of protocol is undoubtedly Uniswap.

After the Uniswap frenzy, we had many cloned protocols like Sushi Swap and a whole series of protocols with token names linked to food…

Before the recent appearance of Binance SmartChain (BSC), most liquidity pools were deployed on the ethereum network. It was therefore mainly ERC-20 tokens.

In recent times, we have seen a very strong enthusiasm for Binance SmartChain with versions similar to Uniswap developed this time on the Binance Smart Chain network. Among these projects which are gaining strong popularity, we can cite PancakeSwap, Bakery Swap or Burger Swap. This time around, the pools contain mainly BEP-20 tokens.

What is the difference between centralized and decentralized platforms?

The big difference between these two types of platforms is above all the fact that centralized platforms use order books while DEXs use liquidity pools.

To explain it simply, the order book groups together and displays all orders currently open on a given market. In centralized platforms, traders buy and sell among themselves. And, these different operations can be read on the order book.

The order book is at the center of all centralized platforms (CEX). This order book shows the buy and sell orders of traders. This is how they can trade assets, to put it simply.

As for decentralized platforms, there is no order book. To have an order book, you would actually have to have an instance that would manage the order book, in fact.

Thus, liquidity pools have emerged as the ultimate way to solve the liquidity problem on DEXs. This replaces the order book model which comes from classic finance and which was clearly not suitable. Indeed, this model has proven to be ineffective in a decentralized platform. We tried initially and the gas fees on Ethereum and the slowness of transactions made these platforms unpleasant to use.

This is why liquidity pools have emerged as the ultimate and ideal solution. They provide continuous, automatically managed liquidity.

Magnificent, isn't it?

How do liquidity pools work?

This is where liquidity pools come into play. It is innovation that has allowed decentralized platforms to exist, without using an order book.

Those responsible for automated market (AMM) changed the situation. This is a significant innovation that enables on-chain trading without the need for an order book.

When a trader executes a trade on a decentralized platform, he executes his trade on the liquidity pool. For example, a buyer does not need to have a seller for the transaction to be completed. Each user will make their operation using the liquidity pool in fact.

In a centralized platform, if there is a buyer of an asset, then that means there is a seller selling that asset to the buyer. You follow?

Conversely, in a decentralized platform, the buyer will purchase the asset directly from the liquidity pool. It interacts directly with the pool. There is no need to wait for a seller to show up.

And that is the whole point of decentralized platforms and liquidity pools.

As we are in a decentralized protocol, it is a smart contract which will manage the liquidity pool. Even transaction fees are managed by the smart contract based on the total transactions that took place in the pools.

What are liquidity pools used for?

Liquidity pools have made Automated Market Makers (AMM) possible and effective. And if they were so popular, it was mainly for the promises of returns that they displayed.

There were many people who wanted to participate as a liquidity provider for example. This enthusiasm was explained by the fact that they received interesting rewards, sorts of crypto passive income, in a way.

However, it is not only AMMs and decentralized platforms that use liquidity pools. These are certainly the most well-known and popular, but they are not the only ones.

Liquidity pools have made it possible to create a new type of remuneration for crypto-holders. For example, we can think of Yield Farming, also sometimes called Pool mining.

In the case of Yield Farming, protocols have improved and we have seen more advanced forms of remuneration. For example, the liquidity providers not only earns part of the commissions from the transactions carried out but also the native tokens of the platforms used.

Depending on the project, this could be governance tokens or pool tokens. Some liquidity providers are interested in governance tokens, especially if they want to fully participate in the development of the project in question.

How to join a liquidity pool?

This will depend on the platform you choose. In general, you must first go to the platform's website then connect your Metamask wallet for example or another wallet that integrates with different DeFi protocols.

Remember that you must first have funds in your wallet such as ETH to be able to participate in the protocols.

Now that your portfolio is connected with the platform, then you can start participating in the liquidity pool by contributing liquidity to it.

Then it's up to you to find a pair that suits you. You will need to check the returns, the pool ration, the exchange rate, etc. to make an investment that will be profitable.

What are the benefits of liquidity pools?

Very clearly, the great advantage of liquidity pools is that they provide a significant supply for traders who want to use DEXs. This has made decentralized trading much easier and more efficient.

This also brought a new way to make money with cryptocurrencies, particularly with Yield Farming. Protocols like Uniswap or Yearn.Finance also rewards liquidity providers with their own tokens as well.

This has also made DeFi increasingly popular. And that can only be beneficial in the long term for the mass adoption of cryptocurrency, we could say.

Liquidity pools, what are the disadvantages?

For AMMs to work properly, it was necessary to create powerful smart contracts to keep the liquidity pools functional.

This is when the concept of “impermanent loss” was introduced. It is a kind of automated dollar value loss for liquidity pools.

If you also want to provide liquidity to an AMM, you should consider impertinent losses. Even if very often this remains very slight, it can constitute a significant loss in certain situations.

A major disadvantage of decentralized platforms is the risk of hacking, Rug Pull and computer bug as was the case with HotDogswap, for example.

Likewise, there have been certain cases of founders who created cloned platforms to leave with part of the funds. There are also simply bogus protocols which have no other purpose than financial speculation. In the short term, this can be beneficial but in the long term… Not really, as you can imagine.

So much for the definition of liquidity pools. Hopefully this has helped you see things more clearly. This is once again a central concept in DeFi technology.

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Note: No financial advice is given in this or any other article on zonebitcoin. This is information of which you are the sole judge and master. Be responsible with your investments and only invest as much as you are willing to lose.

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