The great and powerful world of finance runs on liquidity. Without available funds, financial systems come to a halt. DeFi, which stands for decentralized finance, is no different.

DeFi activities, including lending, borrowing or exchanging tokens, are based on smart contracts. These are fragments of self-executing codes. Users of DeFi protocols “lock” crypto assets into these contracts, called liquidity pools, for others to use.

Liquidity refers to how easily users can exchange one crypto asset for another on an exchange. On a decentralized exchange, liquidity is directly related to the number of tokens locked up in the liquidity pool. If a token lacks liquidity, holders will not be able to sell their tokens whenever they want. Many decentralized exchanges allow market makers to create multiple liquidity pools with different crypto coins. Interested in learning more about crypto liquidity pools, how do liquidity pools work, and more? Then read on!

What Are Liquidity Pools?

Liquidity pools are smart contracts containing locked crypto tokens that platform users have provided. They are a crypto industry innovation with no direct equivalent in traditional finance. In addition to providing a lifeline for the core business of the DeFi protocol, liquidity pools also serve as hotbeds for investors with an appetite for risk and high returns. They are used to provide decentralized trading, lending, and many other functions.

Many decentralized exchanges (DEXs) rely on liquidity pools. Users, called liquidity providers (LPs), add the equal value of two tokens to a pool to create a market. In exchange for lending their funds, they earn trading fees from trades that occur in the pool in proportion to their share of the total liquidity.

How do DeFi pools work?

For any economic activity to take place in DeFi, there must be a cryptocurrency that needs to be supplied in some way. This is what liquidity pools are for. On centralized exchanges, this role is fulfilled by order books and market makers.

When someone sells an A token to buy a B token on a decentralized exchange, they rely on tokens in the A/B liquidity pool provided by other users. Therefore, when they purchase B tokens, there will now be fewer B tokens in the pool, and the price of B tokens will rise. In other words, it is the economics of supply and demand.

Source: Freepik

Liquidity pools have emerged as a completely new concept in the crypto sphere. Let’s take a look at some of the top cryptocurrency liquidity pools at the moment.

Uniswap

It is a decentralized ERC-20 token liquidity pool that supports Ether (ETH) and ERC-20 token contracts in 1:1 ratio. It can be called unique for its flexibility in launching new exchange pairs in new liquidity pools for any token without fees.

Balancer

Balancer is the next-gen liquidity pool. A decentralized liquidity pool also serves as a price sensor and non-custodial portfolio manager. Balancer features a modular pooling protocol that supports multiple pooling opinions and is flexible for its users.

Bancor

This liquidity pool is an Ethereum-based top-notch platform that uses algorithmic market-making methods for leveraging pooled liquidity. It resolves the concern of volatility in liquidity.

Curve Finance

It is an Ethereum-based decentralized liquidity pool tailored for Stablecoins trading. One of the main benefits is reduced slippage due to a non-volatile stablecoin.

Convexity Protocol

It is another excellent decentralized crypto liquidity pool tailored for ERC-20 tokenized options contracts. Convexity Protocol stands out from the rest for the facility of creating collateralized option contracts and selling them as tokens.

DeversiFi

DeversiFi is a decentralized and non-custodial liquidity pool powered by STARKEX smart contract. This liquidity pool has high transaction speeds ranging up to 9000 TPS with a layer 2 scaling engine. It also features support for private and public crypto wallets alongside off-chain trades and maintaining on-chain balance.

Source: Freepik

Yield Farming vs. Liquidity Pools

The first step in yield farming is adding funds to the liquidity pool (particular smart contract). These pools provide a marketplace where users can exchange, borrow, or lend tokens. Once you have added your funds to the pool, you are officially a liquidity provider.

The main advantage of yield farming is passive income. DeFi farming can currently provide more profitable interest than a traditional bank, but there are risks. Interest rates can be volatile, making it difficult to predict rewards.

As for liquidity pools, their primary rationale is intuitive. They can be called smart contracts containing locked crypto tokens provided by platform users. They work on their own and don’t need intermediaries to make them work. They are supported by other code snippets such as Automatic Market Makers (AMMs), which help balance liquidity pools using mathematical formulas.

How Risky Are Crypto Liquidity Pools?

The algorithm that determines the price of an asset may fail due to large orders, smart contract failure, and other problems.

A pricing algorithm that constantly adjusts based on the trades in a liquidity pool determines the price of assets in a liquidity pool. Suppose the price of an asset differs from its price in the world market. In that case, arbitrage traders taking advantage of the price difference between platforms will profit from the variation and eventually correct it.

In the event of price fluctuations, liquidity providers may experience a loss in the value of their deposits, which is known as a non-permanent loss. However, once the provider withdraws their deposit, the loss becomes permanent.

DeFi users face other risks, such as smart contract failure, if the underlying code is not verified or completely secure. Make sure you understand all the risks before placing any funds in liquidity pools.

Conclusion

Liquidity pools are one of the key technologies at the heart of the DeFi tech stack. They enable decentralized trading, lending, profit-making, and so much more. These smart contracts are used in almost all areas of DeFi, and will most likely be popular among traders, investors and crypto enthusiasts worldwide for a long time to come.

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Disclaimer. This material should not be considered as a basis for making investment decisions or as a recommendation to participate in investment transactions. Trading digital assets may involve significant risks and can result in the loss of invested capital. Therefore, you must ensure that you fully understand the risk involved, consider your level of experience, investment objectives, and seek independent financial advice if necessary.