Guarding The Liquidity Pair
A liquidity pool is a pool of crypto tokens secured under a smart contract. These tokens provide decentralized exchanges with the essential liquidity they require. The term "liquidity" refers to the ease with which one can swap a crypto token for another. Such ease is essential to the DeFi ecosystem because of the numerous financial activities carried out in it.
DeFi systems use a technology called Automated Market Maker (AMM) to ensure that users are able to buy and sell cryptocurrencies whenever they want. AMMs are open and efficient for anyone with a crypto wallet and thus democratize access to trading and market making in ways the world’s never seen before. Liquidity pools ensure that buy and sell orders are carried out no matter the time of the day and at whatever price a user wants to trade without the need for any direct counterparty. Investors won't need to find a seller to buy a token: all that is needed is sufficient liquidity in the pool.
For each transaction they make, users will contribute a small percentage to support liquidity. This means that the more transactions are made, the greater the liquidity pool becomes. This increase in liquidity rewards investors, since the liquidity pair is the cash pool from which they will draw to take due profits.
The algorithm ensures that there is always liquidity in the pool, no matter the trade size. A liquidity pool is, by default, a 50:50 ratio of 2 coins. Let's say 50% UNIQO and 50% BUSD. When a user buys UNIQO with BUSD, the pool will start to lose UNIQO and get more BUSD. The algorithm increases the price of UNIQO in order to keep the ratio regulated. The process is a self-regulated automated reaction to the market's needs, based on the scarcity principle.
- There's no need to connect to other traders to trade because there is always liquidity as long as client assets remain in the pool.No need to worry about finding a counterparty agreeing to trade at the same price: instead, the algorithm adjusts the value of crypto based on the platform's exchange rate.
- With liquidity pools, no seller can demand high market prices. Likewise, buyers cannot devalue the market price below the average price. As a result, the transactions are smoother, and the market is more balanced.As soon as liquidity is deposited in the pool for the first time, smart contracts take complete control of setting the price.
- The provision of liquidity is not limited to market makers: anyone can provide liquidity. Listing fees, KYC requirements, and other barriers associated with centralized exchanges are not required for liquidity pools. To provide liquidity to the pool, a user simply needs to make a deposit that is equal in value to the assets and pay the associated fees (in Uniqo's case liquidity providing is taxed as a sale).
A liquidity pool is an important component of DeFi: it helps carry out many DeFi activities like trading, yield farming, lending, arbitrage trading, and profit-sharing. In addition, users can also get passive income by becoming liquidity providers.
With liquidity pools, investors can trade without the fear of market makers' price manipulation, increasing the trust that traders and liquidity providers have in cryptocurrencies and DeFi at large.
Last modified 4mo ago