Last updated on March 7th, 2023 at 11:42 am
Introduction
Both the cryptocurrency and financial markets depend on financial liquidity in some way. It is a process that quickly and effectively turns assets into cash while preventing sharp price fluctuations. However, if an asset is illiquid it takes a long time to convert asset to cash.
The higher the liquidity of an asset better will be the trading as the traders will not have to wait for orders to get through. Slippage is another possibility or the difference between the price you wanted to sell an asset for and that price.
Imagine waiting in a fast-food restaurant to place your order. Having a lot of cashiers is like having liquidity. Orders and transactions could be completed more quickly, which would please customers.
Illiquidity, on the other hand, is like having one cashier serving a long line of customers. Customers would become dissatisfied as a result of slower orders and transactions.
In Blockchain & Cryptocurrencies, a Decentralized Finance (DeFi) system is largely created by liquidity pools.
The buyers and sellers of an asset in traditional finance provide liquidity. DeFi, on the other hand, depends on liquidity pools to run. Without liquidity, a decentralized exchange (DEX) is similar to a plant without water. It won’t last. DEXs are given a chance at survival by liquidity pools.
What is a Liquidity Pool?
A smart contract-locked digital hoard of cryptocurrencies is a liquidity pool. This generates liquidity to enable quicker transactions. A liquidity pool’s automated market makers (AMMs) are a key component.
Instead of using a traditional market of buyers and sellers, an AMM protocol uses liquidity pools to enable the automated trading of digital assets.
In other words, users of an AMM platform contribute tokens to liquidity pools, and the AMM itself sets the price of the tokens in the pool.
Additionally, blockchain-based online games and yield farming require liquidity pools. Users of various cryptocurrency platforms are encouraged to participate in liquidity pools (LPs), which are created for this purpose.
Liquidity provider tokens (LPTs) are awarded to LPs after a predetermined period of time. These are a fraction of fees and incentives equal to the amount of liquidity they supply. On a DeFi network, LP tokens can be applied in various ways.
Why Are Crypto Liquidity Pools Important?
Anyone with experience trading in the traditional or cryptocurrency markets can inform you of the possible drawbacks of entering a market with little liquidity. Slippage will be an issue when attempting to enter or exit any trade, whether it involves a low cap cryptocurrency or a penny stock.
Slippage is the discrepancy between a trade’s anticipated price and the price at which it is actually executed.
When a large order is executed but there isn’t enough volume at the chosen price to maintain the bid-ask spread, slippage can also happen. Slippage is most common during times of higher volatility.
The bid-ask spread of the order book for a particular trading pair determines the market order price utilised during times of high volatility.
The same is with low activity in a typical order book model. This demonstrates that it is located in the middle of the range. This range is between the price at which sellers are willing to sell the item and the price at which buyers are willing to purchase it.
However, inadequate liquidity can lead to more slippage and trading prices that are executed at prices significantly higher than those of the market orders, as shown by the bid-ask spread for the asset at any particular time.
By offering incentives for users to provide cryptocurrency liquidity in exchange for a cut of trading commissions, liquidity pools seek to address the issue of illiquid markets.
No buyer and seller matching are necessary when trading using liquidity pool protocols like Bancor or Uniswap.
This implies that users can easily exchange their tokens and assets using liquidity provided by users and conducted through smart contracts without involving a mediator.
The Unexpected Value of Crypto Liquidity Pools
When trying to simulate the traditional market makers in the early stages of DeFi, DEXs experienced issues with crypto market liquidity. By offering users incentives to provide liquidity rather than requiring a seller and buyer match in an order book, liquidity pools solved this issue.
This enabled the DeFi sector to grow by offering a potent, decentralized solution to the liquidity problem. Although liquidity pools may have developed out of necessity, they have introduced a novel way to provide decentralized liquidity algorithmically through user-funded, incentive-driven pools of asset pairs.
How does a Liquidity Pool Work?
For a specific asset pair, each pool establishes a new market. Liquidity deposits are made by depositing an equal value of two assets like Ethereum & BNB that are locked in a smart contract, regardless of how many tokens this equals for each.
Based on how much liquidity you have contributed to the pool, you receive a reward for staking in the form of liquidity provider (LP) tokens.
So what occurs after a pool is established, and money is deposited? Liquidity pools involve a pair of tokens, as was already mentioned. The exchange of these assets creates a market for traders and offers access to ongoing liquidity.
The ability to facilitate trades in a way that offers a more reliable buying and selling process has been made possible by depositing funds. The price can go up or down depending on supply and demand and is automatically determined by the ratio of tokens in the pool.
Best Liquidity Pools in the Market
The providers of cryptocurrency liquidity pools are crucial in addressing the order book model’s problems with insufficient liquidity. Crypto exchanges won’t rely on bidders and takers to fill the order book because of this.
Additionally, conventional crypto exchanges won’t bother doing that once more. They frequently manipulate trades to attract investors. So let’s find out what caused liquidity pools to be necessary.
Prior to now, there was not enough liquidity in the traditional markets, such as those for forex, stocks, and cryptocurrencies. A buyer will have to wait for a seller to set prices before making a trade. There won’t be a trade until both parties agree on a price.
Trades, however, might not occur or occasionally take more time. Finding a way to provide liquidity is essential in order to address the order book’s bureaucratic nature, which discourages potential investors and investment.
1. Uniswap
Uniswap is a decentralized exchange for ERC-20 tokens that supports 50% of Ethereum contracts and 50% of contracts for other target assets (ERC-20 tokens). It enables a decentralized exchange of ETH for any other ERC-20 token.
It runs an open-source exchange where you can create new exchange pairs in fresh liquidity pools for any token without incurring any listing fees. However, the platform levies a 0.3% swapping fee, split with the liquidity providers. The token list is available here, and you can add to it or start from scratch.
You deposit cryptocurrency to get a Uniswap token when you provide liquidity, just like other providers of liquidity pools.
For instance, you will get the same amount of Uniwap token when you deposit DAI. It consists of a number of liquidity pools, including AD, LGO-WETH, yDAI, yUSDC, yUSDT, and many others.
2. Curve Finance
Curve is a decentralized liquidity pool for stablecoin trading built on Ethereum. It provides users with low slippage because the stablecoin is not volatile, much like Convexity. The platform lacks a native token, but a Curve token (CRV token) launch may exist.
Seven pools on the platform each have a pair of ERC-20 pools. It supports exchanging for assets in the pools Compound, PAX, Y, BUSD, sUSD, Ren, and sBTC as well as a variety of stablecoins.
3. Balancer
It is built on Ethereum and serves as a liquidity provider, non-custodial portfolio manager, and price sensor. Anyone can build or add liquidity to flexible pools and make money from trading commissions.
Various pooling types, including private, shared, and smart pools, are supported by the composable Balancer pooling protocol. Only the owner has full permission and can update parameters in a private pool. As opposed to private pools, all variables, including weights, tokens, fees, etc. are set in a shared pool permanently.
Because anyone can add liquidity and the Balancer Pool Token tracks the ownership of the pools, there is no special privilege. On the other hand, the smart pool is an additional form of private pools where smart contracts govern transactions. But it accepts liquidity anywhere and uses the Balancer Pool Token to track transactions.
The protocol introduced in March 2020 recently distributed a governance token called BAL to liquidity providers through a procedure known as liquidity mining.
In addition to DIA/USDC, USDC/BAL, and NMR/WETH, Balancer also offers other liquidity pools.
4. Bancor
An Ethereum-based Blockchain protocol called Bancor makes use of pooled liquidity. It utilizes “Smart Tokens,” which are algorithmic market-making mechanisms, to ensure liquidity and accurate prices by maintaining a fixed ratio in relation to connected tokens (such as Curve, Uniswap, and others). g. and changing their supply.
Bancor relay refers to its liquidity pool. It introduces the Bancor stablecoin to address the liquidity volatility caused by the reliance on the native token, BNT. As a result, it permits the pooling of liquidity between the BNT token, Ethereum or EOS tokens, and its stable coin (USDB).
As a result, it uses BNT, which currently supports the Ethereum and EOS chains, to enable swapping between other blockchains. Bancor has variable fees of 0.1-0.5 percent, depending on the pool, as opposed to Uniswap, which has a fixed swapping fee.
5. Kyber Network
Kyber is an on-chain liquidity protocol built on Ethereum that enables DApps to offer liquidity to improve user experience. Because of this, users are able to buy, sell, and receive different tokens from vendors and wallets all at once.
Its native token, KNC, is used for ecosystem management and rewards. As a result, holders stake the token to participate in governance and receive the pre-set reward set forth by the smart contract.
6. Convexity Protocol
A decentralized liquidity pool provider is called Convexity. It creates an all-encompassing framework for otokens, which are fungible ERC-20 tokenized options contracts. Users can create collateralized options contracts and then sell those contracts for tokens.
It has a small number of applications because it is a new idea. Liquidity insurance is one unique use case for the platform. As a result, it is safer for new traders or liquidity providers.
7. ICTE
This liquidity pool is among exchanges. It runs a cross-blockchain DeFi protocol that links local cloud-based exchanges. The project contends that linking exchanges will address latency, security, and custodial management issues while offering enormous liquidity to stakeholders.
Though part of the global ICTE Alpha server infrastructure, each exchange runs independently.
8. DeversiFi
DeversiFi is a decentralized, non-custodial exchange with a high transaction volume. Up to 9,000 TPS can be attained using the layer 2 scaling engine from StarkWar.
It provides an aggregated liquidity pooling and a fee close to zero due to its high speed.
The native’s smart contract, called DeversiFi zkSTARK, can accept deposits from private and public cryptocurrency wallets thanks to the DeversiFi protocol. Traders carry out off-chain transactions and on-chain balance through the smart contract. The protocol’s native token, NEC token, is used for the operations.
Conclusion
Liquidity Pools are required to conduct regular, unbiased and quick trades. They serve as incentives to the investors who provide liquidity. Imagine buying your Ethereum and keeping storing it for eternity.
While one may like this type of long term investing, others may want quick exchange and money by regularly buying and selling Ethereum. Imagine if there are no sellers of Ethereumand you want to buy it. How will the scenario work then?
This is where Liquidity Pools helps investors, they provide liquidity to the market. They are great and innovative tools to earn rewards and have revolutionized the Decentralized Finance sector of the Cryptocurrency Industry
