June 16 2021
DeFi 101

Liquidity Pools Simplified

Liquidity Pools Simplified

4 min read

You certainly have heard these words flying around in DeFi recently. It’s how fast these new terms come up, even the pros have to keep up or be left behind.

Liquidity pools and liquidity mining have become the rave of the moment. Just another way to earn rewards and also facilitate growth in the DeFi sector.

<text-h2>So what exactly are liquidity pools?<text-h2>

Liquidity pools are smart contracts with collective funds otherwise known as locked tokens. These tokens are provided by users called liquidity providers (LPs). What this does in essence, is provide liquidity of trading token pairs to DeFi platforms, especially decentralized exchanges. They are also fundamental to facilitating lending, borrowing, flash loans and other DeFi-goodness activities.

Straight to the point, this is you locking your token pair in a DeFi platform to help make sure there’s enough of the token pair in circulation and help boost liquidity of the platform. Of course, you get good rewards for doing that. It ain’t free lunch!

Read more on how to earn rewards from liquidity pools here.

<text-h2>Why are liquidity pools necessary?<text-h2>

In a typical centralized exchange setting, trading involves using the order book model. This model triggered the need for market makers who help to facilitate trade and maintain balance among trading pairs. These market makers are always ready to buy or sell any asset necessary to ensure traders don’t have to wait for other parties to show up. Basically market makers ensure there’s always liquidity in the market.

However in DeFi trading, incorporating the order book model and market makers is quite difficult, expensive to maintain and requires a lot of transaction time. This is why DeFi liquidity pool was developed, by initiating the automated market makers (AMM) model via smart contracts.

The AMM model allows for on-chain trading without need for order books and actual market makers. The liquidity pool is already pre-funded and when you initiate a trade, it won’t be with a counterparty, but rather with an already funded liquidity pool (smart contract). In order for you to buy, all that’s needed is enough liquidity in the pool. You won’t need a seller present. Unlike in the traditional sense of trading where there’s an actual seller, your trade would be governed by the AMM in the pool. Picture the AMM as a bot that you trade with except it is trustless, decentralized and can reduce your risks of slippage.

AMMs changed the game for DeFi and has continued to grow in popularity, thanks to Uniswap. Although first initiated by Bancor, Uniswap contributed more to its popularity and immense growth. AMMs depend on LPs to provide liquidity pairs to a pool (i.e. smart contract). Its advanced mode of operation and popularity is why CDzExchange uses AMMs as well to facilitate trade.

<text-h2>Hold up, so what’s the benefit of being an LP?<text-h2>

Of course, there’s gotta be incentives for LPs to provide liquidity in the first place. LPs earn rewards from fees collected on each trade executed on the DeFi platform using the liquidity pool. Typically, these rewards are in the form of tokens and grow in proportion to the amount of trades conducted.

Heads up though, you gotta be aware of a major risk with liquidity pools before you dive in, it’s called impermanent loss. Don’t worry as we got you covered. We’ll be giving you more details on this risk in the coming posts. So hang in there and be a smart navigator in the DeFi realm.

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