Hello and welcome to Issue 006, where we'll dive into Liquidity Pools.
Long story short, Decentralized Finance (DeFi) has revolutionized the crypto industry, but before DeFi, investors had to heavily depend on centralized exchanges and banks for trading and securing profits.
🧪 Why it matters?
- Centralized cryptocurrency exchanges operate in a similar way to native stock exchanges. We have sellers, and we have buyers, and they all come together to place orders. So, the sellers aim to sell at the highest possible price, and the buyers want to beat down the price to the lowest price possible. Simple.
- Liquidity pools allow traders to trade tokens (and coins) even if there are no sellers or buyers.
- The more investments in a pool and the more liquidity the pool has, the easier trading becomes.
🔍 Problem
Actually, the problem has a name: the problem of illiquid markets.
Liquidity: the availability of liquid assets to a market or company.
Order book model (I'll count it as a problem) - A person cannot trade if their highest bid is lower than the lowest ask, which presents a poor design for illiquid markets.
The lack of ready buyers leads to more significant differences between the seller's asking price and the buyer's bid price.
The cryptocurrency projects suffer from liquidity issues due to the developing nature of the industry and vast amounts of digital assets.
💡 Solution
The solution goes by the name of Liquidity pools. They use an algorithm (called Automated Market Maker) so that you can always buy or sell an asset no matter how low or high the price is or no matter if there is a buyer or seller to meet your everyday needs.
A liquidity pool is a tool where users can pool their assets in a DEX's (Decentralized Exchange) smart contracts to deliver asset liquidity for traders to swap between coins. Liquidity pools provide much-needed liquidity to the DeFi concept.
🩺 How it works?
We can go very deep with this finance concept but let's keep it short.
The Automated Market Makers (AMM) is the core of the Liquidity pool concept. With AMMs, traders can participate in the liquidity pool facilitated by exchanges. Here traders can enter and exit from their positions on token pairs that would be highly illiquid on order book exchanges.
When a Liquidity pool is built, the LP (liquidity provider) decides the initial base price and sets the equal supply of crypto-asset pairs.
The liquidity providers deposit two currencies of equal proportion to the pool (50-50 ratio)
The algorithm is responsible for determining the pricing of assets based on trades occurring in the pool. It ensures the pool keeps liquidity by raising the price of an asset as the demand increases.
🩺 Why it works?
Keep in mind that with liquidity pools, every transaction has a tax.
Every time you put money into a pool, you earn a share (in liquidity provider token) as you are a liquidity provider.
These fees can be substantial amounts for new pools, but as more and more people join the pool, your cut gets less and less (It also makes the price more stable.)
One of the fundamental things of how a liquidity pool works is that as the pool expands in liquidity, as more money is put into it, it takes considerably more money to move the price of both assets.
⚔️ Players
Uniswap - The first of his kind.
Curve Finance - A decentralized exchange for trading cryptocurrency assets focused on trading stablecoins on Ethereum.
Balancer - An automated market maker for swapping ERC-20 assets easily.
SushiSwap - Ethereum-based decentralized exchange (DEX) based on the code of rival DEX Uniswap but focused on Decentralization.
Bancor - One of the longest-standing cryptocurrency projects and among the first to pioneer decentralized financial applications (dApps) and token swaps.
PancakeSwap - Decentralized exchange built on Binance Smart Chain.
THORchain - Decentralized Liquidity Network built on Cosmos.
Keeper DAO - DeFi protocol allows participants to trade, borrow and stake assets with protection from miner value extracted (MEV) bots that front-run transactions.
Intel.
📡 New projects & Opportunities
DeversiFi: An hybrid Ethereum exchange platform that recently added the option for adding liquidity to pools.