How does the DeFi liquidity pool work?


New York, USA, 3rd Feb 2022, ZEXPRWIRE, Liquidity provision is one branch of DeFi, and it’s about the most popular. Liquidity providers are regarded as the backbone of decentralized exchanges because without liquidity, it’s impossible for transactions to be facilitated, and without transactions, there’s no DeFi. Hence, the liquidity pool needs to be as crowded as it is filled with sufficient assets to see the smooth running of projects on the DeFi space. Have you ever tried swapping your cryptos on a DEX, and you encountered some setbacks? It’s primarily as a result of liquidity. 

On the decentralized finance ecosystem, the liquidity pool is arguably the most advanced of them all because of the number of investors that have chosen this means of earning passive income in the DeFi space. Several innovations and upgrades have been put in place by DEXs to facilitate smooth transaction processes. Liquidity pools are now being highly competitive in the DeFi space, and Uniswap remains one of the pioneers when it comes to pools and creating liquidity on DEXs. 

What are liquidity pools?

The liquidity pool is a reserve of all crowdfunded assets from investors locked in a smart contract to facilitate and execute transactions on a decentralized exchange. So, the liquidity pool, like the name implies, is that insurance you have on a project that keeps the transactions on that project running smoothly. Those who provide liquidity on liquidity pools are regarded as liquidity providers, and they get regarded in the form of LP tokens. These tokens are proportional to the amount of pooled assets and shared amongst all liquidity providers. The liquidity pool, as mentioned earlier, is controlled by a smart contract which is a pre-written code. So, unlike the traditional market where you have a central body governing the transaction process, the liquidity pool has the smart contract to execute every transaction. 

How does it work?

As mentioned earlier, the liquidity pool needs a smart contract to execute all its processes. So, there’s no liquidity pool without a smart contract. What happens on the liquidity pool is basic and easy to understand. Once a project is deployed on the DEX, there’s a need for liquidity to be provided for the token. Most times, the project owners supply as much liquidity as possible. Because liquidity acts as the insurance policy, it’s one of those means of knowing if a project t is legit. So, once the project has its liquidity locked, it becomes a safe buy for investors. Once the liquidity is supplied, this means that every transaction that would be carried out on this network would have to pay transaction fees, which are then paid to liquidity providers in the form of LP rewards as a form of payment for trusting in the project. So, to swap a coin successfully, liquidity needs to be available for both coins. That means you need to have enough liquidity for coins A and B. The main aim of providing liquidity is to ensure seamless transactions. If a project doesn’t have enough liquidity, it will cause the transactions to lag. It would also mean an increase in transaction fees. 

The liquidity providers get rewards according to their stakes and according to the number of liquidity providers available on that project. So, the price is continually provided via the AMM in the liquidity pool, checked for balancing according to demand and supply influence.

Benefits of the DeFi liquidity pool

The liquidity pool and the liquidity providers are regarded as the backbone of the decentralized exchange. That means the exchange can’t run smoothly without these investors. Here are some of the other benefits of the DeFi liquidity pools

It helps facilitate seamless transactions

If there’s any reason why the liquidity pool is important, it’s because of this. Other branches in DeFi are such that they rest on this same liquidity. When it comes to yield farming, it involves staking, and the process will remain impossible without the concept of liquidity mining. Hence, for DEXs to enjoy fast and seamless transactions, enough liquidity needs to be supplied to the liquidity pools.  

Helps to increase user adoption

As mentioned earlier, the main reason why it’s advisable for project owners to provide liquidity for their project once it is deployed is that no investor might be willing to invest their asset as liquidity, knowing they stand at the first line of action. So, to make them understand and see why their project is different, they need to provide liquidity. So, the liquidity pool helps to tell which project to invest in, increasing the number of investors on such a project. 

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Published On: February 3, 2022