Cryptocurrency and financial markets both depend on liquidity. It takes time to convert an asset into cash when there is not enough liquidity.
High liquidity means that the process of turning assets into cash while preventing sudden price changes is quick and effective.
Liquidity pools play an important role in creating decentralized finance (DeFi) systems.
Analogy: Liquidity can be compared to having lots of employees working in a company. This will speed up operations, transactions and customer services.
However, illiquidity is having several customers and only one employee which results in a situation of inefficient work.
In conventional finance, buyers and sellers of an asset provide liquidity. DeFi solely depends on liquidity pools. A decentralized exchange can’t survive without liquidity.
What is a Liquidity Pool?
A liquidity pool is a digital supply of cryptocurrency secured by a smart contract. Assets in a liquidity pool are priced by automated market makers (AMMs). In decentralized exchanges, assets are priced based on an algorithm instead of through an order book like in traditional exchanges.
A liquidity pool helps in maintaining liquidity on a network by rewarding users who add assets to the pool. These users get liquid pool tokens as rewards, which are a part of the fees from trades that occur in the pool.
Users can use the tokens for exchanges and smart contracts on DeFi contracts. Most DeFi exchanges that use the tokens on the Ethereum network are Uniswap and SushiSwap. PancakeSwap uses BEP-20 tokens on the BNB chain.
How Do Liquidity Pools Function?
A liquidity pool encourges members to deposit digital assets in the pool. It also compenstates members by giving them rewards that can take the form of cryptocurrency or a portion of the trading commissions paid by the exchanges.
With a liquidity pool, you don’t have to worry about finding a trading partners with the same interest in cryptocurrencies. All exchanges in the pool will happen automatically using smart contracts.
Liquidity pools regulate the worth of cryptocurrencies with the market exchange rate. This will reduce the chances of running into people who are selling their holdings at crazy high prices or buying them at low prices.
If you’re using crypto exchanges, you won’t have to trade on your own. The exchange will obtain assets from the liquidity pool that has already been funded produced from exchange rates. The process is therefore circular and transactions run smoothly.
Risks of Liquidity Pools
However, as much as liquidity pools can save you a lot of trouble, ignoring the dangers associated with smart contracts can result in significant losses. A liquidity pool acquires your assets once you contribute them. The contract alone will serve as the custodian and you can lose your money in the case of a systemic mistake.
Also, be sure to avoid projects where designers constantly change the rules of the pool. This gives them the chance to cause harm for instance by seizing the pool’s money.
Lastly, delivering an AMM liquidity can cause quick losses that results in monetary loss. Be sure to conduct thorough research before investing in double-sided liquidity pools.
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