The DeFi market up to now has developed very strongly compared to previous cycles with basic models such as AMM, Lending, Yield Farming and many other advanced models, however, one thing is indispensable in all All of these models are Liquidity Pools. So what is Liquidity Pool? Join Weakhand to find out why Liquidity Pool is the lifeblood of the DeFi market.
What is Liquidity Pool?
Liquidity Pool Overview
Liquidity Pool is a smart contract containing one or a group of coins and tokens locked inside. Liquidity Pool exists in a completely decentralized way because almost no one can arbitrarily withdraw all the assets contained in the pool.
History of formation of Liquidity Pool
Before the development of Liquidity Pool, traditional intermediary platforms such as Coinbase or Binance acted as liquidity managers and users had to deposit money or other assets into these platform accounts. However, these platforms are responsible for securing users’ funds and if they are hacked, this money can be lost.
One problem is that most of the initial DeFi projects used the order book model of centralized exchanges, which caused the liquidity of the DeFi market to be heavily fragmented and the trading experience User behavior is very bad when price slippage is high.
The birth of Liquidity Pool has solved most of the above problems from decentralization to liquidity fragmentation, thanks to which most current DeFi projects have to build Liquidity Pool as their lifeblood.
How Liquidity Pools Work
The components participating in a Liquidity Pool are:
- Pool creator
- Liquidity Provider
- Trader
Basically, Liquidity Pool’s operating mechanism will operate around the 3 main components above as follows:
- Step 1: The pool creator creates a new Liquidity Pool with specified parameters such as the ratio of tokens in the pool, transaction fees, etc.
- Step 2: Liquidity Provider will deposit its assets into the pool according to the initially specified token ratio.
- Step 3: Traders who use activities related to this Liquidity Pool will have to pay a fixed fee to the Liquidity Provider.
What Are The Applications Of Liquidity Pools?
DEX
Decentralized exchanges (DEXs) often use an AMM model to create liquidity for users’ trading pairs. Basically, AMMs are Liquidity Pools that allow Liquidity Providers to provide one or more pairs of tokens into smart contracts.
The first project to build AMMs was Balancer, but to talk about the most successful project, we must call the name Uniswap as it continuously improves its platform through versions such as:
- Uniswap v1: Allows offering a pair of ERC-20 tokens and ETH.
- Uniswap v2: Allows a pool to be paired by a pair of ERC-20 tokens.
- Uniswap v3: Allows users to limit the liquidity provision price range.
- Uniswap v4: Allows Liquidity Pools to be managed by a single smart contract.
Lending & Borrowing
The operating mechanism of Liquidity Pools on Lending platforms is not the same as DEX platforms when users are required to combine asset collateral to borrow the desired tokens. This mechanism also allows users to use Lending platforms as a leverage tool when repeating the borrowing and lending process.
The most prominent project in this Lending & Borrowing segment is probably AAVE when it surpassed Compound thanks to the implementation of its multichain campaign.
Derivatives
In Derivatives, Liquidity Pools are used for the same purpose as DEX when Liqudity Providers are needed to provide liquidity and Traders will trade based on that liquidity source. Currently, the Derivatives market in DeFi is divided into 2 main components as follows:
- Perpetual: With outstanding projects such as GMX, dYdX, Synthetix,..
- Options: With outstanding projects such as Opyn, Dopex,..
The Risks of Liquidity Pools
The 3 main risks when using Liquidity Pools are:
- Rug Pull Risk: This is a risk that projects intentionally create when installing malicious code into their smart contracts, thereby stealing assets and running away.
- Risk of being hacked: This is an external risk when hackers exploit holes in the process of creating smart contracts, thereby stealing user assets.
- Impermanent Loss Risk: This risk occurs when users provide liquidity to Liquidity Pools with at least 2 tokens or more.
Summary
Above is what everyone needs to know to understand what Liquidity Pool is and why this is the lifeblood of the DeFi market. Hopefully, through this article, Weakhand has brought useful information to serve everyone’s research process.
