How Does Liquidity Pool Works in DeFi?
To appreciate Decentralized Finance, it is important to understand how does the liquidity pools works. This entails knowing what liquidity pools are, how they work, and why they are needed in decentralized finance. All of these are what we will be examining as well as the differences that exist between liquidity pools across different protocols.
What Are The Liquidity Pools?
Liquidity pools, in simple terms, refer to a pool of tokens locked in a smart contract. These tokens are used to facilitate crypto trading by liquidating them. Liquidity pools are extensively relied upon by many decentralized exchanges to increase user participation and facilitate trade. Liquidity was introduced by Bancor, but become widely known when it was adopted by Uniswap. Liquidity works under the hood making use of automated market-making.
Why Are Liquidity Pools Needed in Decentralized Finance?
Many of the popular cryptocurrency exchange platforms make use of the order book model similar to that which is used by traditional exchanges. This model requires buyers and sellers to come together to place and take orders. In this model, buyers only make bids for crypto assets coming at the lowest price. Sellers, on the other hand, only accept bids that come at the highest price. This makes trading a lot more interesting and sometimes very much difficult because it takes both parties to reach an agreement before a trade can be made.
The challenge with this trading model happens when either the seller or the buyer is unwilling to reach a compromise. There is also the challenge of shortage of coins which makes it difficult to leave the market to the forces of demand and supply. To salvage any of these situations, the market makers come in to facilitate trade.
These market makers are entities willing to buy or sell assets at a particular time. These market makers rely on liquidity pools to make coins available for trade. This way, users do not have to wait for the presence of a buyer or a seller before they trade. They can trade directly with these market makers who have provided liquidity.
This model is something that can be recreated in decentralized finance except that it will be slow, expensive, and stressful for users. The order book model relies heavily on market makers and their activities in the market. Without these market makers, it is almost impossible for liquidity to take place.
Asides from this, market makers also tend to hike prices and cancel orders made by users on the exchange which is not a fair market policy. Ethereum, for example, is not a great crypto option for this order book model. The gas fee charged for interacting with the smart contract delayed transactions, and numerous trade request makes it difficult for users to update their orders.
To present a different model from the order book, there is a need for liquidity pools. Liquidity pools are a better innovation that works well in a decentralized setting. They make transactions in the crypto market faster, safer, and create a better user experience for traders. Having understood why we need liquidity pools in decentralized finance, let us go on to examine how liquidity pools work.
Liquidity Pools - How Do They Work?
To keep it simple and direct, a liquidity pool is made up of two tokens. Every pool is used to create a market for the tokens that make up the pool. So, a liquidity pool can contain ETH and DAI both of which will be available on the exchange. For every pool that is created, the first provider sets the price of assets that are available in the pool. This initial liquidity provider supplies an equal value of both tokens to the pool.
In the example above, ETH sets the price of assets in the pool and provides an equal value of both ETH and DAI on the Uniswap platform. Every liquidity provider that is interested in adding to the pool subsequently maintains the initial ratio set for the supply of tokens to the pool.
Every time liquidity is supplied to the pool, the provider gets a special token that is referred to as the liquidity pool tokens based on how much liquidity the provider has in the pool. All liquidity pool token holders are entitled to a 0.3% fee which is distributed based on the proportion of input. To get back underlying tokens and every percentage earned off participating in the pool, the requesting provider is expected to burn their liquidity tokens.
Price adjustment on decentralized exchanges that make use of liquidity pools is determined by a mechanism known as the Automated Market Maker (AMM). Many of the known liquidity pools use a constant algorithm to keep the product of token quantities for both tokens exact. With this algorithm, the price of tokens in the pool increases as token quantity increases.
The price of tokens in every liquidity pool is determined by the ratio of tokens in it. The size of the trade-in proportion to the size of the pool also determines the price of tokens. A big pool and less trade equal the low cost of tokens. Small pools and bigger trades equals the high cost of tokens.
Liquidity pools are a great plus for the decentralized finance (DeFi) as they ensure traders don't have to wait on market makers before trading. Liquidity pools and automated markets are simple but extremely advantageous protocols that are doing much better than the centralized order book. There are different types of liquidity pools that decentralized exchanges can choose from to make trading easier, faster, and better for their users.
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