Non-technical breakdown of liquidity pool in DeFi

Before the concept of decentralised finance (DeFi) was introduced, only central organisations like stock exchange authorities or banks could provide liquidity pools that make investing easier and more convenient. That’s because running them require an extensive list of paper works and costly infrastructure, making it expensive and inaccessible to the public.

Now, with Defi, you can enjoy greater opportunities for credit as well as high returns without going through central authorities. Learn more about liquidity pools in DeFi and find out how you can use them to make the most out of your investment here at BTC Post!

Getting deeper into the pool: What and how’s of liquidity pool in DeFi

Liquidity pools play an essential role in the DeFi ecosystem since they are used to facilitate decentralised lending, trading and exchange. If you want to know more about them, their use, how it works and what it does, you can find your answers in the information below: 

What is DeFi? 

Before diving deep into the technicalities of liquidity pools, you need to know what DeFi means first. The shortened word for decentralised finance is used as an umbrella term for peer-to-peer exchanges in public blockchains that first began in the Ethereum ecosystem. 

The DeFi network allows you to use the same services as banks without a lengthy process. You can purchase insurance, trade assets and derivatives, lend, borrow and even earn interests without the hassling processes of traditional liquidity pools handled by banks. 

Additionally, DeFi uses a peer-to-peer framework of exchange, which limits the transaction between two people instead of routing it to a central figure. Since there is no central authority, the liquidity pool in DeFi allows users to make pseudonymous transactions open to all possible exchanges.

What is a liquidity pool in DeFi? 

A liquidity pool in DeFi is a collection of assets locked in a smart contract. You can use these smart contracts to facilitate your loans, exchanges and other financial services. 

In a liquidity pool, you have people who act as liquidity providers (LP). They add an equal value of at least two tokens to a pool to create a market where people can borrow, lend or trade crypto. In exchange for providing the funds in the pool, liquidity providers earn incentives equivalent to their share in the pool. 

Since DeFi is decentralised and uses automated market makers (AMM), which removes any intermediaries in the crypto trading process making the market accessible, anyone with the means can become a liquidity provider and earn fees from the exchange that takes place in their pools. 

How does a liquidity pool in DeFi work? 

Liquidity pools operate almost in the same way as traditional exchanges. They allow you to use financial services albeit without slippage, high gas fees and lengthy transactions. To understand how it works, you must first familiarise yourself with how they are made. 

A liquidity pool is created once a liquidity provider locks at least two assets in a smart contract. These assets would then be used as the funds that would facilitate the exchange, loan, trade and more in the pool. 

Exchange fees and interest in some of the transactions will come back as incentives to those that provided the funds in the pool. These incentives are proportional to a liquidity provider’s share in the pool. 

Instead of having a central authority matching market orders to complete transactions, a liquidity pool has liquidity protocols that act as the automated market makers or AMMs. These protocols are the ones that offer rewards to the liquidity providers in the form of transaction fee shares and crypto tokens. Some of the most popular AMMs include Bancor, Uniswap and Balancer. 

Use cases of liquidity pools

If you are interested in diving right into the liquidity pool in DeFi, here are some of the amazing ways that you can benefit from its features: 

Yield farming

To give investors a better trading experience, some protocols offer higher returns to LPs who provide liquidity for incentivised pools. Participating in these pools to get the highest amount of LP tokens is what we call liquidity farming. This is one of the best ways for liquidity providers to optimise their incentives in a protocol or market.

Yield farming allows investors to lock their assets within a blockchain protocol to generate tokenised rewards. The idea behind this use case is to stake assets in different DeFi applications to maximise your earnings and receive higher returns. 

The only downside is that it also has a higher risk since your funds would be distributed to incentivised pools and trading pairs that have the highest trading fee and incentive payout across the platform. 

With this type of investment method, you immediately put your investment on the highest yielding asset pair. 

Mint synthetic assets 

Another use for liquidity pools is minting synthetic assets on the public blockchain. Synthetic assets are far from the traditional derivative assets but act and feel the same as the traditional ones. This blockchain-based cryptocurrency has a value that is based on the assets that you have used as collateral for its existence. To create these synthetic assets, you need to offer collateral in the liquidity pool and connect it to a reliable oracle. 

Risk insurance 

Most of the DeFi applications are supported by liquidity pools, which makes them perfect for smart contract risk insurance. 

Join the DeFi liquidity pool party today! 

Liquidity pools are the core technology that serves as the foundation of DeFi. It allows every interested investor to lend, trade, exchange and yield rewards using smart contracts that protect your funds. As for whether it is worth your investment, you can refer to its use cases that present all the benefits you can enjoy in DeFi liquidity pools. However, investing in them seems more fitting for people who already have experience in complex crypto market analysis since you constantly need to read through the case of multiple assets and get a good grasp of the market phase before you can invest in a liquidity pool.

The pools, however, are open to everyone so if you think you have what it takes to become a liquidity provider, then dive right into the liquidity pool in DeFi!