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A DeFi liquidity pool is a smart contract that locks tokens to ensure liquidity for those tokens on a decentralized exchange.
Liquidity pools, in essence, are pools of tokens that are locked in a smart contract. They are used to facilitate trading by providing liquidity and are extensively used by some of the decentralized exchanges; their role is to increase the liquidity of the market among market participants.
Liquidity Pools provide a user-friendly platform for both users and exchanges. The user does not have to meet any special eligibility criteria to participate in liquidity pools, which means that anyone can participate in the provision of liquidity for a token pair. In the DeFi ecosystem, liquidity pools play an essential role, and the concept has been able to increase the extent of decentralization.
In its simplest form, a single liquidity pool contains two tokens, and each pool establishes a new market for the same pair of tokens. DAI/ETH is perhaps a clear example of a popular liquidity pool at forbitswap. When a new pool is created, the first liquidity provider is the one who decides the initial price of the assets in the pool. The Liquidity Provider (LP) is encouraged to provide the pool with an equivalent value of all tokens. Based on the liquidity provided to the pool, the LP receives special tokens called LP tokens in proportion to how much liquidity they provide to the pool. A charge of 0.3% fee is allocated proportionally to all LP token holders when a transaction occurs in the pool. The LPs need to burn their LP tokens if they want to get their underlying liquidity back, plus any unpaid fees. By utilizing a deterministic price algorithm, any token swap within a liquidity pool results in a price shift. This process is also referred to as an AMM.
The reason that liquidity is so important is that it largely determines how the price of an asset can shift. In a market with low liquidity, a relatively limited number of open orders are open on both sides of the order book. This suggests that one trade can shift the price significantly in any direction, making the stock unpredictable and unattractive. For this reason, liquidity pools are an important part of the Decentralized Finance (DeFi) revolution.
Liquidity Pools are intended to successfully address the low liquidity problem and thus ensure that the price of a token does not fluctuate significantly after executing the order of a single large trade. Decentralized Exchanges offer bonuses to those who invest in the liquidity pools to maximize participation. The user has to deposit money into the liquidity pool to reap the benefits and take advantage of it. Liquidity Pools are regulated by one or more smart contract protocols. The number of funds to be invested and the proportional ratio of each token will vary between different DeFi platforms.
To provide $50 in liquidity in an ETH/USDC pool, a deposit of $50 in ETH and $50 in USDC is required. In this example, a total deposit of $100 is required. In return, the LP collects tokens for the liquidity pool. These tokens reflect their proportional pool share and allow them to withdraw their pool share at any time. Every time a seller places a trade, a trade fee is deducted from the trade, and the order is sent to the smart contract with the liquidity pool. The trading fee is set at 0.3% for most decentralized exchanges. In this case, if you deposit $50 ETH and $50 USDC, you will make 1% of the pool with your donation. You will then receive 1% of the 0.3% trading fee for one of the specific trades.
Guaranteed liquidity at any price level: Traders do not need to be directly connected with other traders as liquidity is constant, as long as clients have invested their assets in the pool.
Automated Pricing Enables Passive Market Making: LPs put their money into the pool, and the pricing is controlled by the pool’s smart contract.
Everyone can become and be a Liquidity Provider: Liquidity Pools do not require listing fees, KYCs, or other obstacles associated with centralized exchanges. If an investor wants to provide liquidity to the pool, he only needs to deposit the equivalent of the assets.
Lower gas fees: Gas fees are reduced by the minimal smart contract design offered by decentralized exchanges such as forbitswap.
The return of the Liquidity Pool depends on three factors:
- 1.The asset prices upon deposits and withdrawals.
- 2.The size of the Liquidity Pool.
- 3.The trading volumes.
It is very important to remember that, in proportion to what was originally invested, investors would end up removing some assets. This is where the market movement can work either with you or against you.
It's better to consider the potential risks. Some of the associated liquidity risks are listed below:
- 1.Impermanent loss
- 2.Possible smart contract bugs
- 3.Liquidity pool hacks
- 4.Systemic risks
Before you want to join a liquidity pool, it’s important to stress out the impact of impermanent losses. Impermanent loss describes the temporary loss of funds occasionally experienced by liquidity providers because of volatility in a trading pair. This also illustrates how much more money the LPs would have had if they had simply held onto their assets instead of providing liquidity. Let’s say you have $50 in ETH and $50 in SUSHI tokens, which add up to a total of $100. If you deposit your tokens in a 50/50 liquidity pool, you would have a ratio of 0.024 ETH ($2104) and 3.27 ($15.28) SUSHI tokens. After depositing your tokens into the pool, the ratio and price of the tokens change due to market volatility and trades. As a result, there may be more ETH than SUSHI in the pools at any given time (or more SUSHI than ETH).
A Liquidity Provider is a user who deposits tokens into a liquidity pool. In return for supplying liquidity, users are typically awarded LP tokens that represent the share of the liquidity pool they own. Passive LPs are token holders who wish to passively invest their assets to accumulate trading fees.
Professional LPs are focused on market-making as their primary strategy. They usually develop custom tools and ways of tracking their liquidity positions across different DeFi projects.
Token projects sometimes choose to become LPs to create liquidity for their token. This allows tokens to be bought and sold more easily and unlocks interoperability with other DeFi projects through forbitswap.
Before you get involved in liquidity mining, it’s of primary importance to understand what stands behind the concept of liquidity itself and how it works. Liquidity essentially refers to a fund’s liquidity, which is defined as the ability to buy and sell assets without causing any sharp changes in the asset’s market price. This is a key element in the functioning of either a new coin or a crypto exchange and is dependent on some parameters, including transaction speed, spread, transaction depth, and usability.
Transaction Speed implies how quickly your orders can be executed. If liquidity is low, there’s a high probability of delays, and limit orders may take hours or even days to be processed and executed. On the other hand, for highly liquid pairs, the processing of orders takes just a few seconds.
The bid-ask spread is considered one of the key measures of market liquidity. It reflects the difference between the asking price and the offering price of an asset. The narrower the spread (or gap) between the bid and ask orders, the more liquid the market.
Transaction depth is generally used to describe the degree of market price stability. The greater the depth, the less significant the impact of a particular number of transactions will be on the price.
Usability is a determining factor, as well. The more often a cryptocurrency is used as a means of payment, the more liquid it becomes. Consequently, if more merchants start accepting crypto as a payment medium, they will contribute to the wider adoption and usage of crypto in transactions.
Trading in the DeFi space encompasses a range of activities, from derivatives trading to margin trading to token swaps, and happens across an ever-growing and integrated network of exchanges, liquidity pools, and marketplaces. Crypto traders on decentralized exchanges benefit from lower exchange fees, faster transaction settlement, and full custody of their assets.