The Beginners Guide To Understanding Liquidity Pools
What Is Liquidity and How Does It Work?
Decentralized applications are known for non-third-party transactions, meaning that if you’re a buyer, you don’t need a seller immediately before you can make a purchase.
For this to function properly, there needs to be adequate liquidity at all times. And these are stored in liquidity pools, and functions using the Automatic Market maker protocol (AMM).
The AMM is a protocol that calculates prices (using a formula) and processes trade orders instantly, using liquidity from the Liquidity pool.
Order books are used by centralized exchanges. This arranges and pairs the buy and sell open orders on a market pair and executes them, and the fees are high when compared to using AMMs.
The AMM protocol removes the need for another counter order (non-peer to peer). Rather, it interacts with a smart contract that already has funds and executed trades.
Who provides these funds stored on liquidity pools? Of course, anyone can. They’re called liquidity providers.
Liquidity Providers add an equal amount of funds (Liquidity) to token pairs and are rewarded with a share of the gas fees according to their contribution to the pool.
Other uses of liquidity pools
Liquidity pools can further be used for yield farming. This is where funds added to pools can be staked to generate yield for Liquidity providers.
This can also serve as a means for distributing a new token. Crypto projects can decide to distribute a new token only to people who provide liquidity to a particular crypto token pair.
In the case of governance, when there is a high number of token votes needed to push a proposal, this can be put together in a pool and all participants can decide on a common vote.
Risks
There may be some risks involved in using liquidity pools. The most prominent being impermanent loss.
This is the change in the price of the coin(s) for which you’ve provided liquidity, from when you staked them. The higher the change, the higher the loss.
When providing liquidity, this should always be noted and checked at all times.
In summary, Liquidity Pools are a very core and important aspect of DeFi, which helps in processing transactions, yield farming, and other use cases.
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