What is a Liquidity Pool?
Liquidity pools facilitate different transactions in Decentralized Finance (DeFi), for instance, lending, trading, yield farming, on-chain insurance, and lots more. The pools are the foundation of Decentralized Exchanges (DEXs). Today, our post will define liquidity pools, their relevance to DeFi, and more.
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Let’s get started from the very beginning.
What is a Liquidity Pool?
First, the term ‘liquidity’ in DeFi refers to how easy it is to swap one asset for another or convert a crypto asset into fiat money. Therefore, a Liquidity Pool is a reserve of two crypto tokens locked in a smart contract and used for crypto exchanges. The most common use of a liquidity pool is a Decentralized Exchange (DEX) operating on the Automated Market Maker (AMM) Model.
Fact: A pool’s low liquidity level leads to volatility and causes severe fluctuations in that crypto’s swap rates. High liquidity means that heavy price swings for a token are less likely to happen.
To put it into perspective. Suppose Ndlovu wants to swap IVE for ADA on an AMM-based DEX. He will go to the ADA_IVE pool, deposit the amount of ADA he wants to receive in exchange for an amount of IVE as determined by the smart contract in place. For this to be successful, the ADA_IVE pool has to have a sufficient amount of ADA and IVE Token. So he deposits the ADA, and he is now able to withdraw and own IVE
Users of liquidity pools are referred to as liquidity providers. They provide an equal value of two tokens in a specific pool to create a market for traders to interact with. These users are charged a fee, usually 0.3% of the quoted price of their trade. In return for creating this ‘market,’ all the liquidity providers in the pool are entitled to a share of the 0.3% that the traders pay to the pool. Interestingly, the trading fees depend directly on their share in the total liquidity.
Note: trading fees vary from pool to pool. These trading fees depend directly on the liquidity provider’s share of the total liquidity.
How do liquidity pools work?
It is essential to know how liquidity pools work on centralized exchanges to understand how liquidity pools (Decentralized exchanges) work.
Centralized exchanges (traditional finance and crypto exchanges) use Order Books, allowing traders to buy or sell orders.
Order books are electronic records of buy and sell orders for financial instruments (coins, assets, tokens, securities) organized by price level.
For every buyer who wants to buy an asset at the lowest price possible, a seller tries to get the maximum price for the quoted asset. Now, these trades get locked in the order book, where the consensus on price is required from both parties to get the trade executed.
There can be situations where a consensus never happens and trades never get executed. There are not enough takers, and there is a liquidity crunch in the exchange. These problems are tackled by the Market Makers (MM).
These market makers provide liquidity to the market, thereby supporting quick buy and sell situations for the buyers or the sellers in cases where only one party (buyer or seller) exists.
Order Book & Market Makers are great options for Centralized exchanges but not decentralized exchanges. The Order Book approach leads to slippage and latency in market price discovery. DeFi doesn’t depend on external market makers to support trade because it can be costly and have a high turnaround time. Asides from that, DeFi aims to eliminate third parties. Hence it relies on Automated Market Makers (AMM).
It is impossible to discuss liquidity pools without highlighting AMM. AMM is at the center of liquidity pools. It allows traders to participate in a liquidity pool facilitated by exchanges.
Relevance of Liquidity Pools to DeFi
Whenever a Liquidity Pool is created, a Liquidity Provider sets an initial base price and sets the equal supply of crypto-asset pairs. The rule of equal supply applies to all other Liquidity Providers willing to provide liquidity to the pool.
As against the buy-and-sell order used in Order Books, trades in DeFi are executed against the liquidity in a liquidity pool. So if you want to buy IVE, for instance, you don’t have to look for an actual seller to do so. All you need to do is to engage with a Liquidity Pool. Note that Liquidity Pools are governed by Smart Contracts that ensure enough liquidity to facilitate your trade request.
Why do people stake their assets for liquidity pools?
If you have ever asked ‘why people want to stake assets and risk impermanent loss when they can just HODL and see how far it goes?’
Well, the answer lies in the reward system of liquidity pools. First, for every trade in a pool, the Liquidity Providers are rewarded with a portion of the trading fees. The trading fees are shared in proportion to their contribution to their pool.
Fact: we have the interest and other rewards that come with lending and staking — it is popularly called yield farming or liquidity mining.
Second, liquidity pools serve as means to passive income as liquidity providers put their crypto to work through staking and lending. Many DeFi protocols like Surehive give extra rewards to Liquidity Providers (LPs) by adding a traditional yield and governance token. This provides an extra incentive to LPs as they earn an additional stream of income. They can stake their LP tokens and earn rewards on top of the LP fees.
Third, we have a low entry barrier. Compared to traditional finance, liquidity pools allow anyone (not only big investors and institutions) to act as ‘providers’ in a trading system.
Fourth, unrestricted entry and exit conditions. As a liquidity provider, there is no condition to exit. A liquidity provider can decide to withdraw and switch pools at will without sanction.
Role of Surehive in all of these?
There are three things to note here. First, the Surehive ecosystem consists of three unique users — traders, liquidity pool creators, and liquidity providers (LPs). Second, asides from transparency, the Surehive protocol is designed to make DeFi work for everyone (including its three categories of users). This is evident in our UI/UX. Lastly, we highlighted the native tokens as an incentive for liquidity providers in liquidity pools. Surehive has a native token — IVE with practical utilities such as governance rights, group pooling, and trading fee discounts on the Surehive platform. Not to forget, Surehive has a loyalty program that will be discussed in future posts.
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For more information, visit www.surehive.io
Disclaimer: These articles are for informational purposes only and do not constitute any form of financial advice. All mentions of specific products/assets are only for informational purposes. Surehive does not necessarily endorse the usage thereof (apart from where stated otherwise).
Also, it remains the reader’s responsibility to do their due diligence before investing in DeFi products.