Over the years, Liquidity Pools in DeFi protocols have gained formidable popularity. Interestingly, a major share of the growth of DeFi points towards the decentralization of liquidity by leveraging global liquidity pools.
Both the crypto and financial markets rely heavily on liquidity. It refers to the ease with which assets can be converted to cash quickly and efficiently while avoiding large price swings.
DEXs rely on these pools for survival. Market makers, on the other hand, make this possible by providing liquidity for cryptocurrency exchanges, resulting in a liquid, decentralized financial system.
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What’s Liquidity Pool?
A Liquidity Pool is a crowdsourced pool of cryptocurrencies or tokens that are locked in a smart contract and used to make trades between assets on a decentralized exchange (DEX).
Instead of traditional buyer-seller markets, many DeFi platforms use automated market makers (AMMs), which leverage liquidity pools to allow digital assets to be traded in an automated and permissionless manner.
Liquidity Pools are the foundation of various types of decentralized exchanges like Uniswap, SushiSwap, and PancakeSwap amongst others. These pools are designed to incentivize users that provide liquidity, called Liquidity Providers (LPs).
After a certain period of time, LPs are rewarded with liquidity provider tokens (LPTs), which are a fraction of fees and incentives equal to the amount of liquidity supplied. LP tokens can then be used in different ways on a DeFi network.
Why liquidity pools
Liquidity pools enable users to trade on DEXs
Liquidity pools provide the liquidity required for decentralized exchanges to function. Without them, trading digital assets on a DEX would be very challenging.
By allowing users to deposit their digital assets into a pool and then trade the pool tokens on the DEX, liquidity pools provide the liquidity required for decentralized exchanges to function.
Liquidity Pools eliminate Counterparty
As we all know, trading involves two parties: one buying and the other selling which is how centralized exchanges function.
Liquidity Pools, on the other hand, eliminate this by using Automated Market Makers (AMMs) to set prices and match buyers and sellers without any direct counterparty for the execution of the trades. This greatly improves the privacy and efficiency of all commercial transactions.
Liquidity pools are incentivized
Liquidity pools pave the way for LPs to earn interest on their digital assets. By locking their tokens into a smart contract, users can earn a portion of the fees that are generated from trading activity in the pool.
This provides an incentive for users to supply liquidity to the pool, and it helps to ensure that there is enough liquidity available to support trading activity on the DEX.
How liquidity pools work
The order book model is used by centralized crypto exchanges to allow buyers and sellers to place orders. In the order book model, buyers seek to purchase an asset at the lowest possible price, while sellers seek to sell the asset at the highest possible price.
Unlike liquidity pools, Automated Market Makers (AMMs) have emerged as a formidable force in altering traditional approaches to trading crypto assets. If a buyer wishes to purchase, they are not required to rely on a seller at this time.
AMMs have evolved as a novel means of enabling on-chain trading without the use of an order book, allowing users to execute trades with regard to liquidity. With no direct counterparty for trade execution, you can easily enter and exit positions on token pairs.
Another intriguing aspect of DeFi liquidity pools is the fact that anyone can become a liquidity provider. As a result, in such cases where there are no exact similarities with the order book model, it is reasonable to assume liquidity providers as the counterparty.
How to Create a Liquidity Pool
In order to create a liquidity pool, you need to deposit pairs of assets into the pool. For example, let’s say you want to create a pool that contains the trading pair TRX/USDT. You would need to deposit an equal value of both assets into the pool.
Although protocols such as Bancor and Zapper are making it easier to deposit cryptocurrency pairs by allowing users to provide liquidity with a single asset. Users save time and effort because they don’t have to perform manual calculations or acquire the second asset.
Below are some educational resources to help you provide liquidity in liquidity pools for different protocols:
Providing liquidity in Uniswap
Providing liquidity in SushiSwap
Providing liquidity in PancakeSwap
Liquidity Pools Vs Staking
Liquidity Pools
AMM technology is used by liquidity pools to allow users to execute trades. Liquidity pools are used by DeFi platforms, such as smart contract-enabled decentralized exchanges (DEXs), to support cryptocurrency trading through Automated Market Makers (AMMs).
Money can be deposited into a liquidity pool by liquidity providers, who can then use AMMs to carry out automated trading. In return, they get rewards like liquidity provider (LP) tokens.
Staking
Staking is the process by which users pledge to secure a Proof-of-Stake blockchain network by locking their crypto assets. Individual nodes are set up by stakeholder organizations to validate transactions and add new blocks to the blockchain network.
Users who deposit crypto funds into a staking pool receive staking rewards for protecting blockchain networks from malicious actors. The blockchain network chooses a validator node at random, with high-stake nodes having a better chance of validating transactions. Users earn governance tokens and a percentage of the platform’s fees with the addition of each new block.
The table below shows a detailed comparison of Liquidity Pools and Staking.
| Comparison | Liquidity Pools | Staking |
|---|---|---|
| Levels of Complexity | Liquidity providers must find a liquidity pool that offers competitive interest rates in order to provide liquidity. They must then choose a token pair and a DeFi platform that provides either a customizable liquidity pool or an equilibrium liquidity pool. Thus requires active management to generate greater returns | Staking is much simpler to understand because users only need to choose a staking pool in a Proof-of-Stake network to stake their crypto assets. Thus staking requires little effort from users |
| Fees | To execute fund transfers, yield farmers must pay transaction fees when switching between liquidity pools to maximize profits. For a simple on-chain transaction, Ethereum users may have to pay high gas fees. | Stakers do not have to pay transaction costs because staking requires locking up user funds with no opportunity to switch pools. Instead, when they validate transactions, they earn a percentage of network fees. Staking has much lower maintenance costs for generating returns when compared to liquidity pools. |
| Token Pairs | Use of Liquidity pools necessitates the use of a pair of tokens, such as BTC/ETH, to provide liquidity to pools. For customizable pools, users can provide a flexible ratio of these tokens to the trading pair. They must, however, supply tokens in a 50-50 split to equilibrium pools with trading pairs of equal value. | Staking only requires users to lock up one token in the staking pool, so stakers do not need to purchase two tokens of equal or variable value to provide liquidity. This lowers the overall cost of staking participation. |
| Profitability Index | Investing in Liquidity Pools provides a dynamic and profitable Annual Percentage Yield (APY) that varies depending on the liquidity pool. The APY varies according to several market metrics, including available liquidity, arbitrage opportunities, and overall volatility. | Staking, provides a fixed APY, allowing users to forecast future returns and plan accordingly. Although the interest rate is lower than in yield farming, a consistent percentage is often preferable for low-risk investors. Furthermore, those who lock up their tokens for longer periods earn higher APYs than those who lock up for shorter periods. |
| Impermanent Loss | When Investors provide liquidity to liquidity pools, they are vulnerable to "impermanent loss." This is the point at which the value of the tokens changes from when they were first deposited due to the volatility of the market. | Staking, on the other hand, is not subject to any kind of temporary loss. Users may lose money if the token prices of their staked assets fall due to a bear market, but because liquidity pools do not adjust the total value, stakers will not lose money due to impermanent loss. |
Cryptocurrency liquidity pools eliminate many of the risks associated with centralized exchanges. Even other crypto exchange methods fall short in many areas where liquidity pools excel, such as speed, confidentiality, security, and profitability.
Like with any financial investment, though, there are some liquidity pool risks to be aware of. During extreme market fluctuations, Liquidity Pools and impermanent loss risk cannot be escaped. This is when the price of assets you deposit into a liquidity pool decreases due to price fluctuations.
Despite this risk, liquidity pools are still regarded as extremely safe. In any other circumstance, they are extremely profitable. Less volatile liquidity pools, such as stable coins, are less likely to experience temporary losses.
If you’re a beginner crypto trader, you can start by investing in more stable liquidity pools with lower rewards. Use them to get a sense of your strategy and the market. Then, investigate the risks and rewards of more incentivized liquidity pools.
Top liquidity pools
Top Liquidity pools in crypto include:
Uniswap
Uniswap is a leader in decentralized exchanges and one of the most profitable liquidity pools available.
It is a decentralized exchange built on the Ethereum Blockchain. especially considering its trading volume.
It offers decentralized trade between ETH and any other type of ERC-20 token. Uniswap has a competitive advantage in that it operates an open-source exchange. The open-source exchange can help any individual launch new liquidity pools for any token without any fees.
Another highlight of Uniswap as one of the best Liquidity Pools refers to the exchange fee of 0.3%. Liquidity providers get a share of the exchange fees according to their share of the Liquidity Pool. When you offer liquidity to the platform, all you have to do is deposit crypto assets in return for Uniswap LP tokens.
For more information, you can check out our detailed review of Uniswap.
Balancer
Balancer is the next big thing in the top crypto liquidity pools list. The Ethereum-based liquidity pool also serves as a non-custodial portfolio manager and price sensor. Users enjoy the flexibility of customizing pools and earning trading fees by adding or subtracting liquidity.
Balancer’s primary strength is its modular pooling protocol. It supports a variety of pooling options, including private, smart, and shared pools. Owners of liquidity pools can only have complete authority over offering liquidity and adjusting parameters in addition to making changes in the private pool.
Unlike private pools, the settings and parameters of a shared pool are fixed. In March 2020, Balancer launched a liquidity mining facility by distributing BAL governance tokens to liquidity providers.
Curve Finance
Curve is a top choice when searching for answers to the question, “What are the best liquidity pools?” Curve is an Ethereum-based decentralized liquidity pool for stable coin trading. Because the stable coin is not volatile, it provides consumers with reduced slippage, similar to convexity.
The platform does not have a native token, but a Curve token may be released soon (CRV token). On the platform, there are seven pools, each with its own ERC-20 pool pair. It allows for swapping for the following stable coins and asset pools: Compound, PAX, Y, BUSD, sUSD, Ren, and sBTC.
Conclusion
One of the most innovative technological interventions in the crypto space is liquidity pools. They are critical to the viability of the existing DeFi technology stack.
Using AMMs, Liquidity Pools streamlined the trading process. Rather than having a seller and buyer match in an order book, they assisted in resolving this issue by incentivizing users to provide liquidity.
Liquidity pooling could also foster a wide range of DeFi use cases, such as decentralized trading, yield farming, lending, and many others. On the other hand, they pose the risk of temporary loss.
As Blockchain technology advances, Liquidity Pools may offer improved accessibility and simplicity, opening up new avenues for DeFi use cases. Liquidity Pools, in the long run, would shape the DeFi ecosystem by providing new and sophisticated solutions.
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