Decentralized Finance (DeFi) is a revolutionary financial system that seeks to offer solutions to several challenges that have griped the traditional financial sectors for as long as it has been around. These include lack of transparency, high transaction fees, and delayed transactions to name a few. DeFi offers a high-quality permissionless and transparent financial system as it seeks to become the mainstream global financial system. Here is what we, News Coverage Agency thought you should know.
What are DeFi liquidity pools?
Liquidity pools are smart contracts where tokens are locked to provide liquidity on a decentralized exchange. Users also referred to as liquidity suppliers or providers deposit their tokens in these pools in return for rewards paid out daily, weekly, or monthly.
Liquidity pools have emerged as an innovative and game-changing way for crypto users to access liquidity and they are a big factor that facilitates trading on Decentralized Exchanges (DEX) by ensuring a constant supply of liquidity.
Like in the traditional financial markets like NYSE and NASDAQ where individuals and firms trade various financial instruments like stocks and bonds, Decentralized Exchanges offer a platform that connects users with excess liquidity to those seeking more liquidity. It is synonymous with saving and borrowing in the traditional financial industry.
Liquidity pools play a big role in the sustenance of various DeFi functions and services like yield farming, borrow-lend protocols, automated market makers (AMM), blockchain gaming, on-chain insurance, and synthetic assets among others.
Examples of major DeFi liquidity pools
Top platforms with strong liquidity pools include;
- Uniswap
- SushiSwap
- Balancer
- Curve Finance
How do Liquidity Pools work?
DeFi platforms use smart contracts to lock up funds in DeFi liquidity pools where other users seeking additional liquidity can borrow. These pools create markets for different asset pairs on the decentralized platform. A liquidity provider sets the initial price for an equal supply of each pair of assets. All other liquidity suppliers willing to supply to the pool adopt the price set by the first provider.
Liquidity suppliers are always incentivized to contribute their assets in liquidity pools to ensure a constant supply of liquidity. A transaction fee from the trade is proportionately distributed among all liquidity suppliers.
Benefits of DeFi liquidity pools
The most common practical use of liquidity pools is to ensure a continuous supply of liquidity on decentralized exchanges. Liquidity suppliers also get a chance to earn from their crypto holding by depositing them in liquidity pools to earn a share of the transaction fees shared among suppliers.
Liquidity pools reduce the risk of slippage as projects and protocols offer incentives to suppliers to ensure their token pools remain large. Users can therefore access other earning opportunities like yield farming.
Risks associated with liquidity pools
Any type of financial investment involves some degree of risks that need to be evaluated before making the final investment decision. The most common risk with liquidity pools is the issue of impermanent loss which refers to the temporary loss of funds by liquidity providers due to price volatility. Other challenges include the possible failing of the algorithm that determines prices, the failure of smart contracts, and the possibility of slippage due to large orders.