What is liquidity pool in DeFi yield farming?

What is a liquidity pool in DeFi?

What is a liquidity pool in DeFi?

As the name speaks for itself, a liquidity pool is a pool of tokens locked in a smart contract. It facilitates transactions in a DeFi protocol. In addition, it is widely used by some decentralized exchanges, which increases market liquidity among market participants. So, what exactly does a liquidity pool mean? Follow this article to find out.

What is a liquidity pool?

Liquidity pools are in general very similar to the notion of pooled funds that existed long before now. To put it simply, it is like a reservoir formed by pooling funds together. Liquidity pools are basically the same, except that they have become popular with the advent of the decentralized finance (DeFi) ecosystem

The fact that liquidity is so important is that it largely determines how asset prices change. In illiquid markets, a relatively limited number of open orders are open on all sides of the order book. This shows that one trade can move the price substantially in any direction, making the market unpredictable and unattractive. Liquidity pools are an essential part of the DeFi revolution, and they appear to have enormous potential. Typically, these pools facilitate the exchange of a large number of assets for any other supported asset.

If you have used a cryptocurrency trading platform, you should know that the transaction of the platform is based on the order model, just like traditional stock markets like NYSE and NASDAQ. In these order-based markets, buyers and sellers each place an order. Buyers want to buy the desired asset at the lowest price, while sellers want to sell the same asset at the highest price. Therefore, buyers and sellers must agree on a price if a deal is to be struck. Two things can happen in a transaction: the buyer raises his bid, and the seller sells at a lower price.

But what if no one else is willing to bid again? Or what if you don’t have enough money to place a buy order? At this time, it is necessary to rely on the participation of market makers. Simply put, a market maker is an entity that facilitates transactions, always taking buy and sell orders, thus providing liquidity. Therefore, users can conduct transactions without waiting for a counterparty to appear.

But market making in the DeFi world is slow, expensive, and hard to use, but without market makers, an exchange would immediately become illiquid. That’s why now is the time to invent something new to make it work more smoothly in a decentralized world. This is why liquidity pools are needed.

How does the liquidity pool work?

Generally speaking, a liquidity pool will have two tokens, and these two tokens form a new market transaction. When a new liquidity pool is created, the first liquidity provider (LP) will set the initial price in the pool, and that LP will be driven to maintain the same value for both assets in the pool.

How does the liquidity pool work?
Photo credit: coinsutra

When the liquidity pool obtains liquidity (which can be understood as capital injection), LP will get a special LP token, which represents the liquidity ratio they provide. When this liquidity pool facilitates transactions, 0.3% of transaction costs will be distributed proportionally to all LP token holders. If LPs want to withdraw the liquidity they provided, the LP tokens they represent must be burnt.

Every time LP tokens are burnt, a price adjustment is initiated based on a deterministic algorithm, the Automated Market Maker (AMM). The basic liquidity pool uses a constant commodity market maker algorithm, which means that the amount of a given two tokens remain constant. On top of that, due to the algorithm, the pool will still be liquid regardless of the volume. The main reason for this is that the algorithm asymptotically increases the price of the token as the target amount increases.

Some protocols, like Balancer, are starting to give LPs more incentives to attract liquidity. This process is called liquidity mining. The concepts of liquidity pools and automated market makers are simple, yet useful. If we don’t have a centralized order book, we don’t need external support from market makers.

Introducing  Yield Farming Opportunities

CrowdSwap is adding new yield farming programs for various chains. So far, users have been able to farm on Polygon and BSC networks. Each of these blockchains has different options, to which new ones are being added as the system updates. To date, the following pools are accessible on CrowdSwap:

BNB Smart ChainPolygon

Participating in these pools is done on CrowdSwap with very easy steps that everyone can follow. The interesting thing about yield farming options on CrowdSwap is that with the cross-chain technology, holders of assets from other chains can take part in these programs. This means that you don’t need to swap your existing tokens to the LP pair before the investment. Check these outstanding features, and a lot more, by visiting the ‘OPPORTUNITIES’ section of the CrowdSwap App.

How much can you make with liquidity pools?

Yield farming, or liquidity mining, is the practice of lending your tokens to a DeFi protocol and receiving rewards in return. Because the reward is often paid in the form of the platform’s native token, the price of the token has a direct effect on your profit. Therefore, how much you can make depends on the price of that cryptocurrency. To learn more about the concept of liquidity mining, read this article.

Final words

Participation in liquidity pools is one of the ways to earn passive income during the bearish market, and it is the go-to choice of many cryptocurrency market investors. Learning how it works is essential to calculate your potential profit and loss (PNL). In this article, we tried to explain what a liquidity pool is and how it works in simple terms. 

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