As the crypto world and blockchain technology advance, they bring forth many changes in other domains, like finance. Traditional finance institutions pose a series of issues and challenges that can be solved through cryptocurrencies. The concepts of decentralization and decentralized finance (DeFi) remove the power from the hands of a central authority and eliminate third-party intermediaries between buyers and sellers.

One of the foundational technologies of the DeFi ecosystem are crypto liquidity pools, basically piles of tokens or digital assets locked together in smart contracts. This short explanation might not be enough to understand what a liquidity pool is and how it works exactly in a decentralized exchange. Keep reading further as we are going to dive deeper into these crypto market liquidity notions!

What are crypto liquidity pools?

As mentioned above, a liquidity pool is a collection of crypto assets locked in a smart contract. These types of funds are used to provide liquidity in decentralized exchanges to solve the illiquidity issues that are typical in these systems.

The decentralized exchanges that leverage liquidity pools also use AMMs ( automated market makers), replacing the traditional order books with pre-funded on-chain liquidity pools for both crypto assets of the trading pairs.

Liquidity pools vs. order books

For better understanding, let’s take a quick look at order books. They are a fundamental part of electronic trading and consist of all the currently open orders for a specific market. Order books are used together with a matching engine in centralized exchanges. The current DeFi ecosystem executes trades on-chain without the need for a centralized party to hold the funds. As such, order books are not suitable for cryptocurrency trading as they require transaction fees that make trading more expensive.

How do liquidity pools work?

First of all, let’s understand what a liquidity provider is. Any user who funds a liquidity pool with their crypto assets is called a liquidity provider. They facilitate trading on the platform and can earn a passive income on their deposits through token rewards or trading fees.

Every time the users pool tokens, they are rewarded with LP tokens in proportion to the amount of liquidity they supplied. During a pool trade, a fractional fee is distributed proportionately amongst the liquidity providers. If the users want to get back the liquidity they provided to the pool, the LP tokens that they received must be destroyed first.

The automated market maker algorithms ensure the tokens’ price stays relative to one another in any given pool, maintaining a fair market price for the tokens locked in a smart contract.

Advantages & risks

Liquidity pools have proved to be a consistent growth factor for the DeFi ecosystem, helping create a sustainable decentralized financial system.  They have many advantages but can pose some risks too:

Liquidity pool benefits

  1. Users don’t have to find themselves a trading partner that values crypto the same way they do.
  2. Since liquidity pools maintain a fair market price of the tokens they hold, there’s no need to negotiate with investors that try to sell at very high prices or buy at shallow rates.
  3. Transactions are smooth and have low fees.

Some risk factors

  1. Smart contract risk refers to the fact that the pool owns your funds. There are no intermediaries involved, but the contract itself could act as the custodian. Any flaw in the system could lead to you losing your asset or assets.
  2. Impermanent loss is another possible risk, as the value of the pooled coins can fluctuate against each other based on supply and demand. If the value of the native tokens decreases exponentially, not even trading fees could cover your loss.
  3. Smaller pools with low liquidity pose a risk, too, as they are more vulnerable to hackers and manipulation tactics like flash loans. Such a technique involves flooding the market with outsized orders, draining the funds of the smart contracts in the process.

Liquidity Pools use-cases

Now that you know what liquidity pools are and how they work, let’s see some of the best use-cases they have:

Yield farming or liquidity mining - Users pool their funds on automated yield generating platforms, creating income or yield. Liquidity mining helps crypto projects distribute new tokens to the users who have contributed to the liquidity pool.

Governance - To put forward a formal governance proposal sometimes requires a considerable amount of token votes. By pooling the funds together, the users can unite around a cause they consider vital for the DeFi protocols.

Synthetic assets minting - The creation of synthetic assets on the blockchain involves liquidity pools also. An overly simplified explanation is that you can add collateral to a liquidity pool and connect it to a trusted oracle, thus obtaining a synthetic token.

Tranching - This concept comes from traditional finance, and it refers to dividing different financial products based on their risks and returns. Liquidity pools can create their own risk and return profiles with these products.

Insurance sector - Smart contract risk insurance is an emerging DeFi sector supported by liquidity pools.

Liquidity pools are without a doubt one of the core components in today’s DeFi ecosystem. They enable decentralized trading, yield production, lending, and other processes. Smart contracts are the backbone of decentralized finance, so it makes sense to get acquainted with them along with basic Tokenomics concepts. Once you understand the basic idea behind a liquidity pool, you can start making passive income with your cryptocurrency.

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