In recent months, decentralized finance (DeFi) has been the center of cryptocurrency discussions. Notably, the liquidity pool is an integral aspect of DeFi. By description, liquidity pools are a pool of tokens that are locked within a smart contract. The tokens are mainly used to initiate crypto trading by liquidating them.
Most decentralized exchanges heavily rely on liquidity pools to increase user participation while simultaneously facilitating trade. Some months ago, Bancor introduced liquidity pools but it was not until when Uniswap adopted it that it became widely known. Notably, a liquidity pool is an automated market maker that offers liquidity to prevent large asset price swings.
The fact that these liquidity pools are important to DeFi has been established. However, many wonder why Decentralized Finance technology needs liquidity pools.
Why Are Liquidity Pools Important?
Most of the commonly-used crypto exchange platforms use the order book model that resembles the one used by the traditional exchanges like NYSE. In this model, sellers and buyers need to come together to place and take orders. Normally, the buyers can only make bids for cryptocurrency assets that come at the lowest price.
On the other hand, the sellers only accept the bids that come at the highest price. Challenges may arise when no party wants to place their orders at a fair price level. Such an occurrence makes trading quite difficult since it takes both of these parties to come up with an agreement before any trade is made.
Such a trading model’s main disadvantage is when the participants fail to agree on a fair price; the trade faces a risk of being off. Another disadvantage arises whenever there is a shortage of coins which makes it highly challenging to leave the market to the forces of supply and demand.
The market makers are introduced to help facilitate trade between the buyers and sellers to salvage the occurrence of these situations. Market makers are individuals or entities that are ready to buy or sell assets at a given time. They are liquidity providers to the sellers and the buyers and they primarily rely on liquidity pools to make coins available for all.
It means that traders do not have to wait for the other party to come into the market before they trade. They can trade directly with the market makers. Thus, the order book model is a viable option for DeFi systems. However, it comes with several flaws. It is slow, expensive, and quite stressful for the traders.
In reality, the market makers are the middlemen and they mostly hike prices and cancel the orders made by the users on the exchange. By all means, that is not a fair market policy. Furthermore, some of the cryptos are not perfect for the adoption of this model. For instance, in Ethereum, the gas fee charged for interacting with the smart contract is responsible for the delayed transactions. The many trade requests also make it quite challenging for the users to update their orders.
Liquidity pools are introduced to fight and solve these underlying challenges with their order book model. They are an upgrade to the order book model, and it is wholly decentralized. The pools make transactions in the cryptocurrency market faster, more secure, and they create a better user experience for the traders.
How Do They Work?
A liquidity pool is made up of tokens and every pool is used to set up a market for the tokens that create the pool. For instance, a liquidity pool may have ETH and an ERC-20 token like Tether (USDT); both of them will be available on the exchange. For each pool that is created, the first provider offers the initial price of available assets in the pool.
The initial liquidity provider sets an equal value of both of the available tokens to the pool. In the example given above, ETH sets the starting price of assets in the pool and offers an equal value of both USDT and ETH on a DeFi platform like Uniswap.
Each of the liquidity providers that are interested in adding to this pool then maintains the initial ratio to get ready for the supply of tokens to the pool. For each time that liquidity is introduced to the pool, the provider gets a unique token that is known as the liquidity pool token.
But it now depends on the amount of liquidity the supplier has in the pool. All of the liquidity pool token holders are entitled to get a 0.3% fee that is distributed subject to the amount of input. To get back the hidden tokens together with every rate earned off partaking in the pool, the requesting provider needs to burn their liquidity tokens.
Price adjustment of liquidity pools in decentralized finance is determined mainly by a mechanism that is referred to as the Automated Market Maker (AMM). A majority of the known liquidity pools use a constant algorithm to maintain the product of token quantities for both tokens. The algorithm ensures that the tokens’ price in the pool increases as the token quantity increases.
The ratio of the tokens in this pool determines the value of the tokens in every liquidity pool. Furthermore, the size of the trade-in proportional to the size of the pool determines the value of tokens. A big pool and less trade ensure that the cost of the tokens decreases. Smaller pools and bigger trades equal a significantly high cost of tokens.
Decentralized Finance (DeFi) platforms are now seeking innovative methods of increasing liquidity pools since bigger liquidity pools majorly reduce slippage and improve their users’ trading experience. Some of the protocols like Balancer reward the liquidity providers with more tokens for supplying liquidity to particular pools. The process is known as liquidity mining.
The merging of Liquidity Pools with decentralized finance is a major addition because it gets rid of the issues of traders having to wait until the market makers come into the market for them to trade.
AMM and liquidity pools are quite straightforward and are an improvement on the centralized order book method that is used in traditional finance. Currently, there are many liquidity pools available for the decentralized exchanges to choose from to make the trading process easy, fast, and better for their customers.
The Takeaway
Liquidity pools play a crucial role in the decentralized finance ecosystem and the concept has managed to make DeFi highly decentralized. Interestingly, liquidity pools make DeFi easier to use for the traders and the exchanges.
For anyone to participate in these liquidity pools, they do not have to meet any special eligibility criteria or fill any KYC forms. Thus, anyone can participate in offering liquidity for a token pair.
Centralization is one of the main worries that cryptos and blockchain aim to address and resolve. Nonetheless, some of the centralized exchanges have had to rely on quite a few market makers to offer liquidity for the coins and tokens for along time. The liquidity pools have managed to provide solutions to the challenge of centralization.
All of the liquidity providers earn through their participation in liquidity pools and as a result of that, user participation is constantly increasing. That will eventually result in more decentralization and can then address the issue of market manipulation. That is one of the main challenges associated with the transparency of the crypto markets.
The simple liquidity pool concept has offered a solution to a big, complex problem with the magnitude of centralization. That has been a major issue for the crypto space up to date. For now, it seems like a solution to this problem might have finally been found.
