A decentralized finance (DeFi) liquidity pool is a smart contract that locks a certain asset to provide liquidity for tokens on a decentralized exchange. Users who provide tokens to the smart contract are also called liquidity providers.
DeFi liquidity pools emerged as an innovative and automated way to solve the liquidity problem in decentralized exchanges. They have replaced the traditional order book model that is actively used by central cryptocurrency exchanges.
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In this model, the stock market; It serves as the marketplace where buyers and sellers come together and agree on asset prices depending on instant supply and demand. However, this model is conditional on having enough buyers and sellers to create liquidity. Therefore, the role of market makers is to ensure that there is always someone to meet the demand and to keep the price at a fair level by regularly contributing to liquidity.
The decentralized exchange model, which was created in the early period, was not found attractive by market makers due to high gas fees and slow block generation time. Decentralized exchanges (DEX) were not chosen to copy the order book system. Therefore, liquidity pools have become the preferred solution in decentralized finance. Thus, continuous and automatic liquidity can be provided for trading platforms.
How do DeFi liquidity pools work?
In the simplest terms, the liquidity pool; It contains two tokens on the smart contract to create a transaction pair.
For example, let’s say you have a pool with Ether (ETH) and USD Coin (USDC). To simplify the process, let’s assume that the price of 1 ETH is equal to 1,000 USDC. Liquidity providers add equal amounts of ETH and USDC to the pool. Therefore, anyone depositing 1 ETH would need to match that amount with 1,000 USDC.
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When a user wants to buy ETH in exchange for USDC, the obligation to find the match of the transaction is eliminated thanks to the liquidity in the pool, and the transaction takes place with the funds in the pool.
Liquidity providers receive rewards for contributing to the pool. When they deposit, they receive a special token representing their stake in the pool. Continuing from the example above, a token with a name similar to ETHUSDC-LP will be issued to the user.
Transaction fees paid by users using the pool to trade tokens are automatically distributed to all liquidity providers in proportion to their share size. Therefore, if the transaction fees in the ETH-USDC pool are 0.3 percent and the liquidity provider also contributed 10 percent to the pool; 10 percent of 0.3 percent of the total value of all transactions.
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When the user wants to withdraw his share in the liquidity pool, the tokens belonging to the pool are burned and the corresponding coins are transferred to the user.
Are DeFi liquidity pools risky?
There is always risk in decentralized systems. For example, the algorithm that determines the price of the asset may not be calculated correctly, large transactions may cause price volatility, and even the smart contract may be incorrectly written.
The price of assets in the liquidity pool is determined by the pricing algorithm, which is constantly adjusted according to the trading activity of the pool. If the price of the asset differs from the global market price, arbitrage traders can take advantage of the price differences between platforms and profit from this price difference.
In the event of price fluctuations, liquidity providers may experience a loss in the value of their deposits, known as an impermanent loss. This loss becomes permanent if the provider withdraws its deposit. Depending on the size of the volatility and the length of time the liquidity provider has invested, some or all of this loss may be offset by transaction fee rewards.
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Due to the pricing algorithm, very large transactions can devalue small pools.
DeFi users should know that if the source code is not audited or completely secure, they may face risks such as smart contract failure or even lose all their investments.
What are the pros of DeFi liquidity pools?
The most obvious benefit of liquidity pools is that they provide an uninterrupted supply of liquidity for traders who want to use decentralized exchanges. They also offer the opportunity to generate income by becoming a liquidity provider and earning on transaction fees.
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Many projects and protocols generate ideas that will offer additional incentives to liquidity providers, reduce the risk of price volatility, and result in better trading experience, to ensure that token pools remain at scale. That is, it is possible to earn more with tokens received as liquidity providers.
How to become a member of the DeFi liquidity pool?
Usually MetaMask or similar Web 3.0 digital wallets are used to participate in DeFi liquidity pools. When the person who has this wallet account enters the site belonging to the pool, a connection is automatically established. Afterwards, tokens can be deposited into the corresponding liquidity pool.
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