Liquidity pools are part of the integral building blocks of decentralized finance. A Liquiditypool is a smart contract that stimulates liquidity in a decentralized exchange by hoarding or locking tokens. Defi exchanges like Uniswap, Curve, and Balanceroperate based on the principle of liquidity pools.
The concept is to deposit digital funds in a large pool. The main aim of liquidity pools is to tackle the liquidity problem associated with digital coin exchanges.
Liquidity pools have found their place in blockchain gaming, borrow-lend protocols, and other domains. In this brief guide, you will learn the benefits and potential risks of liquidity pools.
The Importance of Liquidity Pools
Centralized cryptocurrency exchanges work in a similar way to native stock exchanges. Sellers and buyers come together to place orders. The sellers in the market aim to sell at the maximum possible price. The buyers want to beat down the price to the lowest that they can.
The trade cannot occur until both parties reach a consensus on the price. What happens if there isn’t sufficient liquidity to carry out the trade? The downside of this book order structure is based on the willingness of buyers and sellers to create liquidity.
Market makers are elements that solve this problem by providing enough liquidity to facilitate trades. Maker makers are buyers or sellers who are ready to sell their assets to keep the market moving.
When there aren’t sufficient market makers, trades become costly and slow. For example, Ethereum has significant gas fees and slow block time that deters most market makers. This is the point where liquidity pools come in. Liquidity pools take over the book order used by centralized cryptocurrency exchanges.
How Do Liquidity Pools Work?
Let us use bitcoin and Ethereum as our sample digital coins. To keep things basic, let’s say that 1 BTC is equal to 16 ETH. The market elements aiming to achieve liquidity will bring equal values of both coins to the exchange. They will deposit these coins in a pool to facilitate future transactions.
If a new person wants to trade ETH for BTC, the individual can simply exchange it based on the funds available in the pool. There is no need to wait for a willing party to facilitate the trade. Since liquidity providers are important to the trades, they will receive a unique reward called a pool token.
In this case, the name of this token will be BTCETH. If a liquidity provider provided 5% of the pool and the exchange fee for the BTC-ETH pool is 0.25%, the liquidity provider will get 5% of the 0.25% of the value on every trade.
Create an account with the bitcoin system today and start trading under favorable market conditions.
Limitations of Liquidity Pools
Liquidity pools are not without their drawbacks. It is best to understand the little risks associated with joining one. A pricing algorithm determines the price of the digital coins in a liquidity pool. The pool’s trading activity influences the value of the assets continuously.
When prices fluctuate, liquidity providers suffer impermanent losses that can become permanent if new users withdraw their deposits.Also,the pricing algorithm can fail if someone wants to execute a large trade in a small pool. Sometimes smart contract failures can occur because of underlying technical issues.
Liquidity pools try to eliminate the need for a centralized book order based on external market makers. The elements in the exchange pool their resources together to create liquidity for incoming traders. You can join liquidity pools to win reward tokens.
Some popular Defi liquidity pool platforms include Balancer, Yearn, and Uniswap. To create an account on these platforms, follow the requirements on their website. You will need to link your account with Metadesk or any other Web 3.0 wallet. Keep in mind the possible risks associated with liquidity pools.