Liquidity pools are one of the fundamental parts of the DeFi ecosystem today. It is an essential part of automated market makers (AMMs), lending protocols, yield farming, synthetic assets, blockchain insurance, blockchain gaming and more.
Definition of a liquidity pool
Liquidity pools are the game-changing innovation in decentralised finance (DeFi) that facilitate trading on decentralised exchanges (DEX), they are cryptocurrency/token accounts that are locked into a smart contract.
Why is liquidity important?
Like traditional exchanges, trading on centralised cryptocurrency exchanges is based on the Order Book model, where buyers and sellers place orders.
An order book reflects all the wishes to buy and sell a given asset on the exchange. Each of these desires has been expressed through an order, in which the conditions for the order to be executed have been stipulated.Definition
While buyers try to buy an asset at the lowest possible price, sellers try to sell it for the highest possible price. For the exchange to take place, both buyer and seller must agree on the price.
What if neither the buyer nor the seller agree on the price? Or, what if there is insufficient liquidity for the order to be executed? This is where the concept of market makers comes into play.
Market makers facilitate exchange by being willing to buy or sell a particular asset, thus providing liquidity and allowing traders to transact without waiting for another buyer or seller to appear.
In decentralised finance (DeFi), over-reliance on external market makers can make transactions relatively slow and costly. This is something that liquidity funds can address.
Market Maker and Automated Market Maker (AMM)
Market makers put their own funds to add to a pool of money in a market. They operate with the explicit job of making money from the people who buy and sell them. Often, they make a difference with the money they provide.
The word “automated” in AMM means that there are no entities that are making a market; everything is handled automatically by code, by a smart contract algorithm.
It is software on a blockchain that facilitates exchanges based on a predetermined pricing algorithm. What’s significant about this is that now anyone can be a market maker by simply depositing two [crypto] assets for a single market in an AMM, and the pricing algorithm of an AMM will take over and facilitate the trades for each trader.
It is important for you to know that a small tax fee is charged on behalf of liquidity providers, i.e. those who place two assets in a single market.
This new method of asset exchange represents the foundation of DeFi, crypto and blockchain technology in general. No single entity controls the system and anyone can create new solutions and participate.
Liquidity in Uniswap
Uniswap, a DeFi protocol used to exchange cryptocurrencies, promotes the basic concepts of using Liquidity Pools.
Liquidity Pools, such as those used by Uniswap, use a constant Market Maker algorithm that ensures that the product of the quantities of the 2 tokens supplied always remains the same.
Because of the way AMMs work, the more liquidity there is in the pool, the less slippage of large orders. That, in turn, can attract more volume to the platform, and so on.
On top of that, due to the algorithm, a pool can always provide liquidity, no matter how large a trade is. The main reason for this is that the algorithm increases the price of the token as the desired amount increases.
In the current Uniswap V3, the system is maintained and has been made much more fine-grained and configurable. For example, the TWAP oracles have been made more efficient in order to avoid unnecessary Gas costs. At the same time, the commissions in V3 have been adjusted to allow for so-called flexible commissions.
Thus, LPs have three different types of commissions per pair: 0.05%, 0.30% and 1.00%. In this way, LPs can better adapt to the volatility of the pairs on which they operate.
Benefits of putting your MINX in the Uniswap pool
As a liquidity pool (LP) provider, you receive a 1% commission on all trades made in the pool. In other words, if $200,000 is traded in a month and you have 10% of the pool, you will receive $200. The calculation is very simple:
Fee for the LP = Trade amount * 1% * % pool
- In exchange for providing liquidity, LP’s (Liquidity Providers) get fees from the trades that occur in their pool.
- Your tokens do not suffer or lose value, as they go against a stablecoin (USDT) and therefore the value of the pair is not affected by the volatility intrinsic to other cryptocurrencies.
- You contribute to give more liquidity to the project and other people can buy MINX, this helps to give value to the token.
- You become a pioneer and support the project even more.
- You can withdraw your tokens at any time from the pool.
In short, liquidity pools eliminate the need for centralised order books or order books while significantly reducing reliance on external market makers to provide a constant supply of liquidity to decentralised exchanges.