So, you want to know a little more about what are Liquidity Pools and how they work in the Defi Market?! In a small resume, Liquidity pools are the foundation of automated revenue-generating platforms. There are probably many other uses for them that have not yet been discovered. Read further to learn more about DeFi.
The year 2020 was marked by the rise of the DeFi markets ( Decentralized Finance Markets). Since then, the amount of money inside it has not stopped growing.
Currently, according to the DeFi Pulse website, there are about US$50 billion in protocols that use the Ethereum blockchain. Liquidity pools are one of the fundamental parts of this entire volume.
Total Value Locked (USD in DeFi
Overall, these pools provide a new standard for trading while helping investors return on their investments. In essence, they have tokens locked in a Smart Contract within a Blockchain.
As these platforms are non-custodial, there is no way to deposit funds without executing an order. Therefore, they are fundamental tools to ensure the proper functioning of the market.
As you will note throughout the article, the primary purpose of pools is to facilitate trading by providing liquidity to brokers and an essential part of Automated Market Maker (AMM), loan protocols, yield farming, and blockchain games.
Unlike traditional finance, anyone can trade, borrow or lend to generate returns on DeFi.
The following text is long, but it will show you the importance of Liquidity pools and how to make money from them.
Why is it important to have a Liquidity Pool?
Although the protocols are different, the liquidity pools serve the same need: ensure the presence of liquidity in the protocol at all times.
The most obvious benefit to this ecosystem is that these pools ensure an almost continuous supply of liquidity for traders wishing to use decentralized exchanges.
First of all, it is essential to know that whenever we mention “liquidity” in finance, we refer to the ease and speed with which an asset can be converted into cash. It can be understood that the faster the conversion of the asset into cash, the more liquid it will be.
An asset with little liquidity, therefore, is the most difficult to be redeemed. In DeFi, we can ask for poetic license and change the word “money” to another crypto active.
The critical point is to realize that they aim to solve the low liquidity of Decentralized Applications (dApps) since there is no investment fund or big player to generate it.
With this, the system can ensure that the price of a digital asset does not significantly fluctuate after executing the order for a single large trade.
What are the actors that make it happen and how are the mechanisms?
First, they only exist through one of the main characters: the liquidity providers and users.
As can be deduced, those who provide/provide liquidity for the protocol are called “liquidity providers,” and those who benefit from this deposited liquidity are called “liquidity users.”
In general, market makers facilitate trading, both for those who want to buy or sell an asset, by providing liquidity for traders to trade without waiting for another buyer or seller to show up at the exact moment.
The idea of pools is quite simple, being a reserve of funds stored in a large digital “pool.”
This model means that when someone wants to trade BTC for USDC, they can do so based on deposited funds rather than waiting for a counterparty to show up to match their trade and execute the order.
Two assets are deposited in each liquidity pool, which respects the equation x * y = k. Variables x and y represent the number of tokens.
If a user wants to become a liquidity provider for this pool, he will have to contribute, leaving the same values of BTC and USDC tokens locked in the protocol. In practical terms, if you deposit $100 in BTC, you will have to deposit $100 USDC jointly.
In turn, it will generate liquidity for the protocol to perform a rapid conversion between the pair (BTC-USDC).
The exact procedures for joining DeFi liquidity pools vary by platform. However, you need to know that all transactions and asset prices are determined in the same way: by an algorithm based on the previous trades of the chosen pool.
How can liquidity be provided and what are the benefits?
DeFi, with open arms for participants, creates the potential for a highly diversified liquidity profile as there are drastically lower barriers to entry compared to traditional capital markets.
As said before, the Market Makers (AMM) of the protocols, which can be non-institutional average traders, like you and me, who provide liquidity for trading pairs, are fundamental parts for DEXs – and it’s up to them (us) that this system works without the need for an order book.
It doesn’t sound straightforward to be an AMM, but it’s pretty simple: market makers deposit their tokens in liquidity pools so that users who want to make trades or borrow money can do so.
If you’re creating interest in this topic, it’s essential to know about LPs tokens before going into action.
If you provide liquidity to any decentralized exchange, you will receive tokens representing your shares in the pool. Everyone who provides liquidity on a DEX receives liquidity provider ( LP ) tokens. You will earn passive revenue by owning these tokens through trading fees for the pool you engage.
In plain language, liquidity providers make their crypto assets available to the protocol in exchange for rewards.
One of the first protocols to use liquidity pools was Bancor, but the concept gained more attention with the rise of Uniswap.
Uniswap is one of the exchanges with greater liquidity in the market, precisely because of the large number of LPs on their platform.
Another use case that is gaining traction is participation in governance.
Governance tokens have a feature that has been very popular in the crypto world lately: the power of the vote.
Whoever owns such tokens has the right to vote in these protocols. One example is to vote on which tokens can be used as collateral in negotiations and what percentage of remuneration will be given to each liquidity provider.
Some DeFi projects require a very high token voting limit to create and approve governance proposals. It becomes easier for token holders to meet the required limits by pooling funds in these liquidity pools.
How are return calculations made?
Interest (or returns) paid in this modality, in most cases, are calculated in annual terms.
Unlike Real Estate Funds in the traditional market, which pay dividends once a month, the receipt of income in almost 100% of the protocols in the world of Decentralized Finance happens every second.
It means that it is not necessary to wait for a specific day for you to redeem your passive income.
Most annual returns can be made based on two metrics:
- Annual Percentage Rate ( APR );
- Annual Percentage Income ( APY , its acronym in English;
Although they seem difficult to understand, in practice, it is pretty simple: a pool that uses the APR takes into account the profitability according to simple interest rates. A pool that uses APY refers to earnings based on compound interest.
As for returns, the most significant difference between APR and APY lies in how they relate to your savings or investment growth or your costs.
Since the APY takes into account the effect of automatic reapplication of earnings, it will be greater than the APR. Compound interest can be a powerful tool for increasing wealth: when interest increases, you effectively earn interest, and the longer you invest and save, the greater your money’s growth potential.
Some protocols and liquidity pools offer APR and APY options to their users; others, in turn, are only an option.
What are the risks of DeFi?
When we talk about Smart Contracts, it is essential to emphasize that there are always risks.
While the number of potential use cases and the profit to be made seem limitless, this concept presents risks and possible flaws.
DeFi users face dangers such as smart contract execution errors and protocols vulnerability (even more so if not audited or fully secure), leading to irreversible hacks.
Another point that deserves attention is that markets with low liquidity are more subject to attacks, both in price and the networks themselves. In these protocols, often, a whale can manipulate the price of an asset.
In summary, it is notable that liquidity pools are essential to ensure smooth trading. As it is a very recent market, DeFi is still not known by most people – even those already in the middle of digital assets- making the generation of liquidity necessary so that there are no problems in trading.
Also, another extraordinary thing about Decentralized Finance is that it allows me, you or any other user to earn rates that would typically only be available to brokers and Wall Street moneymakers!
Liquidity pools are the foundation of automated revenue-generating platforms. There are probably many other uses for them that have not yet been discovered.