Erik Weijers, 6 months ago
Liquidity pools are the foundation of Decentralized Finance (DeFi). Anyone can deposit their crypto in these pools, creating liquid marketplaces for loans and trading.
In Decentralized Finance (DeFi), all kinds of trading processes (borrowing, lending, swapping) that normally go through a central authority are taken over by software and distributed among users. Liquidity pools are an example and even an indispensable part of DeFi. Because in crypto, capital is spread across hundreds of different currencies. To make trading possible (e.g. USDC/USDT), there have to be trading pairs. Pools of these are created and anyone can put their own crypto into them.
Suppose I don't plan to sell my USDC for now but want some passive income. Instead of simply holding my USDCs, I put them into a liquidity pool of a DeFi protocol. For example, in a pool where people can trade USDC with another stablecoin, say USDT. At that point, I become a liquidity provider. In exchange for the option I have given to other users to exchange USDC for USDT (and vice versa), I receive a commission (trading fee).
Liquidity pools occur on decentralized exchanges such as Uniswap, Curve (running on Ethereum) and TraderJoe (running on Avalanche). Although Uniswap was not the first to introduce the principle of liquidity pools, this platform did mark the breakthrough of the concept.
Liquidity Pools are automated market makers. The difference with a traditional exchange like the stock market is that there are no order books with buy and sell orders at certain price points. Instead, liquidity pools determine the price of each coin by keeping the product of the price of the two coins constant:
Coin A x Coin B = constant.
This means that if someone buys coin A from the pool with Coin B, the price of Coin A will rise a bit and that of Coin B will fall. Thus, the product remains constant. This is done by automatic adjustment, hence the name automated market maker.
Liquidity pools fit right in with the ethos of crypto. After all, there is no middleman who accrues power and money from the trades. Unless you think of the software as the middleman. In addition, there are a few more advantages:
Trading in liquidity pools is transparent because it can be monitored on-chain. The disadvantage of a lot of trading activity, however, is that a chain can become too crowded. For example, this led to high transaction costs at Uniswap as of the end of 2020. The high volume on Uniswap drove up the price for anyone wanting to do anything with Ether, even outside of Uniswap.
A few more drawbacks/risks:
To make money from liquidity pools, you need to be strategic. The above-mentioned phenomenon of impermanent loss is one that you should particularly keep an eye on. This risk is less with two coins the price of which is correlated. On the other hand, a trading pair in which one of the two is a stablecoin is more sensitive to this risk.
On the other hand, you can also see impermanent loss as an intentional way of automatically rebalancing / taking profits. The moment the value of ETH rises in your ETH/USDC pool, it means that, because of the automatic rebalancing, you take profit in USDC. As long as you are aware of this, this is a viable strategy.
Traditionally, only banks made money on exchanging currency - now it is the users who make their capital directly available for transactions and are rewarded for it. In DeFi, everyone thus becomes a market maker who can earn an income.
Thanks to Shivsak for his clear explanation of DeFi.
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