Liquidity refers to the possibility of an asset being quickly sold and exchanged for another asset without affecting its price. In short, it is an indication of how easily an asset can be converted into cash.
A liquidity pool is an accumulation of digital assets that allows assets to be traded on a decentralized exchange (DEX). A DEX is a type of exchange that functions without an intermediary, allowing assets to be traded with each other directly.
With the DeFi platforms, users can borrow, lend crypto assets, and earn other crypto assets in return. Smart contracts are used to automatically facilitate yield farming, requiring minimum human intervention while conducting transactions efficiently. Yield farming maximizes the user’s returns by depositing crypto assets into a pool with other users.
In this blog we will cover the following:
The main purpose of liquidity pools is to allow peer-to-peer trading to function smoothly on DEXs. By fuelling liquidity constantly through a steady supply of buyers and sellers, liquidity pools ensure trading is executed quickly and efficiently.
Liquidity pools are an integral part of DeFi as peer-to-peer trading cannot function without them. There are several use cases of liquidity pools in DeFi:
When users, also called Liquidity providers (LPs) deposit their digital assets into a smart contract, liquidity pools are created. LPs can then trade these assets with each other on a DEX. Users are issued liquidity pool tokens (LPTs) which represent the LP’s share of assets in the pool.
Yield farming involves a liquidity provider (LP) and a liquidity pool in Decentralized Finance. Think of a liquidity provider as an investor who deposits tokens into a smart contract to fuel liquidity. Yield farming works on the automated market maker (AMM) model which eliminates the need for the conventional order book and instead creates liquidity pools using smart contracts.
AMM deploys a mathematical formula for calculating the need for swapping each asset and the trading fee to be paid out to the LPs is then determined.
Liquidity pools are a part of the Yield Farming process. Yield farming in DeFi begins with the process of creating a pool of crypto assets. The following steps are undertaken to facilitate yield farming:
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Read more: Yield Farming vs Staking in DeFi
Just like any other investment, there are risks with liquidity pools too.
For creating a liquidity pool in decentralized finance, users need to deposit two equal amounts of assets within a pool. This is referred to as the “trading pairs”
For example, if you wish to invest in a pool with the token pair BTC/USDT, you are required to deposit an equal amount of both ETH and USDT into the pool to begin trading.
Generally, one would need equal amounts of assets and manually enter them into the pool to trade. However, Okto, a DeFi wallet app such as Okto makes it easier for users to explore vetted investment opportunities and explore liquidity pools with higher APYs. One of the major hindrances within yield farming is the complexities involved with using various platforms to farm and make additional income on your crypto. However, Okto’s user interface is designed in a way that makes it easy for a novice user to explore varied opportunities across pools on a single app and invest securely.
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Liquidity Pools are needed to facilitate the functioning of the DeFi world by providing liquidity in the market. In exchange, they reward the users through trading fees. Moreover, they provide financial independence as there are no intermediaries involved and are governed by smart contracts that facilitate buying and selling automatically. Eliminating middlemen also increases market efficiency and ensures the smooth functioning of the protocols.
A good liquidity pool in DeFi is one that is less prone to smart contract bugs and has been audited by a reputable company for the same. The protocol should have some form of on-chain insurance mechanism in place to protect its LPs and provide protection for impermanent loss.
Ideally, a good liquidity pool would have a higher trading volume and a large amount of liquidity. One must also consider the fees associated with the pool.
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