What Is a Liquidity Pool?
By disrupting financial intermediaries and allowing users to control their finances, DeFi brings traditional banking services like saving, investing, borrowing, and lending to blockchain technology.
To fully understand, imagine you had access to a savings account that yields 10% a year in USD but without a bank. Imagine you can trade crop insurance with a farmer in India sitting in your office in Dubai.
These use cases have essentially contributed to the exponential growth of crypto adoption. Currently, there’s $43 billion in value locked across DeFi platforms. A report shows that it has increased by over 4x since 2020.
However, beyond these famous financial solutions now available at the fingertips, the popularization of liquidity pools and their use cases, including yield farming, is hugely responsible for the DeFi ecstasy. This guide will teach you what it entails and how it works.
What Are Liquidity Pools?
Liquidity pools are a set of pools of cryptocurrencies hosted and backed by a smart contract. These crypto assets in a pool essentially provide the required liquidity for a decentralized exchange to function.
They play a huge role in facilitating trading on these exchanges, and unlike centralized exchanges, DEX doesn’t rely on intermediaries to regulate funds.
Decentralized exchanges allow users to interact directly with each other using Automated Market Makers (AMMs). This involves mathematical functions that automatically set prices in agreement with the rate of supply and demand.
In other words, a liquidity pool can be described as a pool filled with cryptocurrencies that are easily accessible to anyone that wants to trade. Let’s explore how it works.
How do Liquidity Pools Work?
As mentioned, Liquidity pools are reservoirs of crypto assets created when users lock their assets into a smart contract. In exchange for depositing their assets, users earn a fraction of the transaction fees whenever a transaction takes place.
Users who deposit or lock their crypto assets automatically provide liquidity, liquidity pool tokens (LPTs). These users are called liquidity providers, and the assets deposited represent their share of assets in the pool.
Since the Automated Market Maker automatically sets prices according to demands and supplies, users can swap the liquidity pool tokens for the base token. For example, say you deposit $1000 in a BTC/USDC pair, and you can receive your rewards in BTC for keeping the network secure. Locking cryptocurrencies come with certain periods. It ranges from a week to several months.
Utilities of Liquidity Pools
The growth of DeFi has skyrocketed since, resulting in the rise of many decentralized exchanges providing access to using DeFi liquidity pools. Some popular use cases involve:
Yield Farming
This is the most popular application of liquidity pools. And it involves users providing liquidity by adding funds to a DeFi protocol in return for yields — interests. Several DEX and some centralized exchanges like LBank allow users to deposit their funds and earn rewards known as APY after a period of time.
Governance
Besides depositing funds for interest, liquidity pools also help in governance. With token votes, a network’s decision can be made to establish a proposal for governance.
Wrapping Up
Liquidity pools are innovative concepts in the crypto space. They facilitate the massive adoption of crypto with huge DeFi use cases involving decentralized trading, governance, yield farming, lending, and much more.
While liquidity pools provide easy accessibility to yield farming and other DeFi applications, they present some risks, including Smart contract-based risks and many others. It’s always important to do your personal research before trying anything out in crypto.
Disclaimer: The opinions expressed in this blog are solely those of the writer and not of this platform.
