There has been an explosion of on-chain activity due to decentralized finance (DeFi). DEX volumes can meaningfully compete with the volume on centralized exchanges. As of December 2020, there are almost 15 billion dollars of value locked in DeFi protocols.
The ecosystem is rapidly expanding with new types of products. But what makes all this expansion possible? One of the core technologies behind all these products is the liquidity pool.
What is Crypto Liquidity Pool?
A liquidity pool is a crypto token secured under a smart contract. These tokens provide decentralized exchanges with the essential liquidity they require. The term "liquidity" refers to the ease with which one can swap a crypto token.
Although the decentralized trading sector contains many liquidity pools, only a select few have established themselves as the investors' first choice. They include Uniswap, Balancer, Bancor, Curve Finance, PancakeSwap, and SushiSwap.
How Does a Liquidity Pool Work Versus an Order Book?
A liquidity pool is like a pot containing crypto coins locked up in a smart contract that allows people to trade easily. The importance of liquidity pools is better understood when we compare them with traditional order books.
On the other hand, the order book is a digital list of crypto buy and sell orders arranged by price levels and updated continuously in real time. In simple terms, buyers and sellers submit orders for the number of tokens they want to trade and at what price.
A liquidity pool is, by default, a 50:50 ratio of 2 coins. Let's say 50% Bitcoin (BTC) and 50% Ether (ETH). The pools will lose BTC and get more ETH when you buy BTC with ETH.
As such, the algorithm increases the price of bitcoin and lowers the price of ether to keep the ratio regulated. Besides, the process is a self-regulated automated reaction to the market's needs.
Advantages of Liquidity Pools
There Is Liquidity at All Price Levels. You do not have to connect to other traders to trade because there is always liquidity as long as client assets remain in the pool.
Better Price Balance With liquidity pools, no seller can demand high market prices. Likewise, buyers cannot devalue the market price below the average price. As a result, the transactions are smoother, and the market is more balanced.
Anyone Can Provide and Benefit from It. The provision of liquidity is not limited to market makers, and anyone can provide liquidity. Listing fees, KYC requirements, and other barriers associated with centralized exchanges are not necessary for liquidity pools.
Liquidity Pools Risks
There are also some drawbacks to liquidity pools. They include;
Impermanent Loss- The value of a crypto token may change in comparison to another due to demand and supply activities, leading to an impermanent loss of value. This issue occurs when the ratio of two held assets ends up unequal due to a sudden price increase in one of the assets.
Smart Contract Vulnerabilities- Smart contracts manage the assets added to a pool; there is no central authority or custodian for these assets. Therefore, you could permanently lose the coins if a vulnerability is discovered.
Bottomline
Liquidity pools are one of the core technologies behind the current DeFi technology stack. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power almost every part of DeFi.
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