Liquidity Pools are one of the copious innovations emanating out of Cryptocurrency, particularly, Decentralized Finance (DeFi). The mechanism is also part of the Decentralized Exchange (DEX) development, changing the face of digital assets trading.
Gone were the days when liquidity and volume were so low on DEX, rendering the trading experience nothing to write home about. It was boring and time-consuming to exchange virtual assets on such platforms.
However, DeFi has generated an eruption of on-chain activity, enabling DEX to rub shoulders with CEX. Most of this achievement is due to the engagement of the mechanism known as Liquidity Pools.
DeFi has over $55 billion of Total Value Locked (TVL) in various protocols, providing sovereign financial services immune to central control and censorship. The rapidly evolving space has come out with various unique novelties to enhance the industry.
Besides, Liquidity Pools are an indispensable element of DeFi products and services like automated market maker (AMM), lending and borrowing protocols, Gaming, yield farming, synthetic assets, on-chain insurance, among others. Most of the functionalities in the ecosystem hinge on the availability of liquidity.
A Liquidity Pool
But what are Liquidity Pools? The whole concept is comparable to savings in traditional finance. Financial institutions then lend the funds to those who require capital, in this case in a decentralized manner, without asking anyone for permission.
In the DeFi domain, token hodlers can avail their assets to a protocol in the form of liquidity to expedite decentralized trading, lending, and many more purposes. Those who put their tokens in a pool for such function are called Liquidity Providers (LP).
The LPs receive passive income on their deposit via trading fees based on the rate of the liquidity pool that they contribute. Therefore, instead of making their tokens lay idle in their wallet, LPs put them to good use by making them available in a pool.
Bancor, an Ethereum-based trading platform, was the pioneer of Liquidity Pools, although it became popular through the Uniswap protocol. The enormous distinction here is that, unlike in traditional finance, every process is coded in Smart Contracts and open to the public for verification.
In a nutshell, Liquidity Pools discharge the requirement for Centralized order books as it meaningfully diminishing the necessity of outside market makers to implement consistent liquidity accumulation to Decentralized exchanges.
How They Work
An essential Liquidity Pool forms a market for a selective pair of Crypto on a decentralized exchange, let say GDEFI/ETH). When a Pool is in place, LPs set the opening price and balanced supply of both assets.
The idea of an equivalent amount of the two assets prevails alike for all the other LPs ready to furnish liquidity to the pool. LPs have influences concerning the quantity of liquidity they bring to the Liquidity Pool.
Transaction fees are distributed among all LPs proportionately when a trade gets executed. Diverse smart contracts facilitate different use cases of Liquidity Pools.
Constant Market Maker algorithm, for example, guarantees the regular provision of liquidity. The degree of the tokens in the Liquidity Pool decrees the cost of assets. Moreover, some Smart Contracts provide incentives for LPs with additional tokens. The method is described as Liquidity Mining in the DeFi space.
Types Of Liquidity Pools
Liquidity Pools vary in different sorts of pools, with use cases expanding rapidly. However, Market-Making pools, Lending Pools, and Options Collateral Pools are the widely known ones.
Market Making Pools
Market Making Pools present liquidity for token transactions and structures in the pools shifting with every transaction. A fee applies per trade distributed to the pool participants.
Several devices apply between the various platforms. For instance, the XYK model used by Uniswap and SushiSwap is pretty popular.
The curve designation for stablecoin and comparable token transactions has an insignificant slippage algorithm. The Balancer protocol, on the other hand, favors multiple coins in a pool with the customization of token synthesis rate and transaction charges.
Meanwhile, Bancor v2.1 submits a one-sided presentation and temporal loss security to AMM pools. Kyber Network creates liquidity with an extensive supply construction, while DODO connects an enterprising market maker algo that supports liquidity providers to keep only one variety of tokens in the pool.
Lending pools are the primary decentralized liquidity pools in DeFi, devised to advance the borrowing and lending market. Contrary to the peer-to-peer lending paradigm, where borrowers acquire loans straight from the lenders, it acts as the counterparty directly, with interest on loans set by coded algorithms spontaneously.
Compound and Aave are examples of projects well-known in the lending pools domain. In Compound’s lending model, the interest isn’t distributed but, by holding cTokens, LPs receive earnings automatedly.
With Aave, all deposits in the protocol receive an identical aToken, an Aave interest-bearing token. It is pegged on a 1:1 ratio to the amount of the underlying asset.
Options Collateral Pools
Option Collateral Pools utilize obligatory contract that permits individuals to trade an underlying asset at a predetermined price within a set time frame. It could be either goods, stocks, indexes, among others.
It means the buyer of an option contract has the prerogative, although not the responsibility, to buy or sell the underlying asset. When it comes to Options, to get the right to obtain or retail a singular asset at a decided price, you have to pay the option seller the cost that
referred to as the option premium.
The option buyer funds the option premium and is qualified to rights only, while the option seller holds the advantage as compensation for giving up those rights. Hence, the requirement is that the option seller deposits collateral for the fulfillment of the contract.
GlobalSwap DEX, the GDEFI native decentralized exchange, a fork of Uniswap with its own unique features launching soon this quarter, will feature liquidity pools. You will have the opportunity to provide liquidity with your GDEFI tokens and other ERC-20 tokens.