What Are Crypto Liquidity pools?
Introduction
Decentralized finance has created an explosion of one-chain activity. DEX volume can meaningfully compete with the volume on centralized exchanges. As of December 2020, there are almost 15 billion dollars of value locked in the DEFI protocol. The ecosystem is rapidly stretching with new kinds of products.
What are crypto liquidity pools?
Liquidity pools are pools of tokens locked in a smart contract that locked in smart contracts that deliver liquidity in decentralization exchanges in an attempt to attenuate the problem produce by the liquidity typical of such systems. Liquidity pools are also the name given to the intersection of order which creates price levels that –once reached — see the assets decide whether to continue to move in uptrend or downtrend.
The decentralized exchanges that leverage liquidity pools are the same that make use of an automated market marker-based system. On such trading platforms, the traditional order book is replaced by the pre-funded on-chain liquidity pools for both the assets of the trading pair.
The pros of using liquidity pools is that it does not require a buyer and seller to decide to exchange two assets for a given price and instead influences a pre-funded liquidity pool. This allows for trades to happen with limited slippage even for the most illiquid trading pairs, as long as there is a big enough liquidity pool.
The fund held in the liquidity pools is provided by other users who also earn passive income on their deposit through trading fees based on the percentage of the liquidity pool they provide.
One of the most first decentralized exchanges to introduce as system ETHEREUM-based trading system BANCOR was widely adopted in the space trading in the space after UNIWAPS popularized them.
How do liquidity pools work?
An operation of crypto liquidity pools must be designed in a way that incentivizes crypto liquidity providers to stake their assets in a pool. In this way, most liquidity providers earn trading fees and crypto rewards from the exchanges upon which they pool tokens.
When a user supplies a pool token with liquidity, the provider receives an LP token. LP tokens can be valuable assets in their own right and can be used during the DEFI ecosystem in various capacities.
Usually, a crypto liquidity provider gets LP tokens in portion to the amount of liquidity they have supplied to the pool. When a pool facilitates traffic a fractional fee id corresponding distributed amongst the LP token holders. For the liquidity provider to get back the liquidity they contributed, in addition, to collecting fees from their portion.
Why are crypto liquidity pools important?
Any seasoned trader in the traditional or crypto market can tell you about the capability downsides of entering a market with little liquidity. Whether it’s a low cap cryptocurrency or penny stock, slippage is a concern when trying to enter or exit any trade. Slippage is the difference between the expected price of a trade and the price at which it is executed. Slippage is the most common during most periods of higher volatility and can also arise when a large order is executed but there is no competent volume at the selected price to maintain the bid-ask spread.
This market order price that is used in times of high or low volume in a traditional order book model is resolved by the bid-ask spread of the order book for a given trading pair. This means is not the middle point between what sellers are creating deliberately to sell the asset for and the cost at which buyers are deliberately purchasing. Low liquidity can incur more slippage and executed trading cost can far exceed the original market order price depending on the bid-ask spread for the asset at any given time.
Final Thoughts
Liquidity pools are a collection of crypto tokens locked in smart contracts. The liquidity pools help in doing exchanges between resources on a decentralized trade with the confirmation of liquidity. The liquidity pool helps in carrying out trades between assets on decentralized exchange with the assurance of liquidity. The search for top liquidity pools has bent over lately fundamentally because of the worth benefits they offer. First of all, liquidity pools offer the required liquidity alongside speed and comfort to the whole DEFI ecosystem. Liquidity is a fundamental part of both the crypto and financial market it is how assets are converted to cash quickly and efficiently.
