Liquidity Pools – How it all works
The disruptive effects of the DeFi boom are both staggering and impressive. The total value locked (TVL) in decentralized finance rapidly climbed to more than $26 billion from a humble $600 million just last January of 2020. DEX volume is running to $30 billion a month with loans growing from a patsy $150 million to $4.5 billion.
The DeFi space continues to be creative with innovations that boast of over 200 Dapps, or decentralized applications, with new projects introduced every day. With stats like that, DeFi is giving centralized exchanges a run for their money.
How have this rapid DeFi expansion became even possible can be pinpointed to the one technological product called liquidity pool.
To Define
A DeFi liquidity pool is a process of locking tokens through a smart contract to keep the liquidity of the decentralized exchange. Participating users are called liquidity providers who pool their tokens together in a smart contract.
Solving a Problem
The traditional order book default model of the mainstream financial market was first adopted by the centralized crypto exchanges (CEXs) and DEXs. Buyers and sellers meet and come to terms on the prices of assets according to the relative supply and demand. Creating liquidity, however, rests on the number of buyers and sellers which market makers must maintain to keep prices competitive.
Given this coupled with Ethereum’s gas fees and difficulty in producing blocks, the order book model has not matched the demands of DEXs. The coming of the innovative liquidity pool for automated and uninterrupted liquidity signaled the explosion of DeFi ecosystems.
Benefits
Traders using decentralized crypto exchanges will find massive benefits liquidity pools provide by ensuring a round-the-clock supply of liquidity. Hodlers may want also to take the opportunity to earn from transaction fees by pooling their tokens and become liquidity providers.
They are further incentivized to keep the liquidity pool a sizeable lot, and one is by gaining from yield farming. It is essential to keep token pools large to prevent slippage and enhance the trading experience.
Risks
It is but natural that nascent technologies will pass through challenges and liquidity pools are not exempted. Pricing algorithms rely on the trading activities of the pool to adjust the price of assets. Traders will try to benefit from the variance of an asset price in contrast with global pricings.
Impermanent loss happens for liquidity providers when there are market price fluctuations. But then the loss becomes permanent when an LP withdraws its deposits. Other risks include the failure of smart contracts, audit problems, and loose security measures.
How a Xion DeFi Liquidity Pool Works
To form a trading pair, the DeFi liquidity pool needs to hold two tokens within a smart contract. For example, Xion’s XGT coin will be paired with a stable coin like xDAI to create a liquidity pool where anyone can provide liquidity and trade xDAI with XGT and vice versa.
If, say, 1 xDAI is equal to 1000 XGT, liquidity providers contribute an equal value of xDAI and XGT to the pool. So if someone is pooling 1 xDAI, it would be matched with 1000 XGT. The pool’s liquidity makes it possible to trade anytime based on the existing funds instead of waiting for a trader to match the trade.
Xion makes use of Uniswap contracts since they are open-sourced, gas efficient, and a tried and tested platform that first popularized liquidity pools.
The token itself need not be restricted to the xDAIXGT pool, though, so users are free to open their own pools on Uniswap, once enough traction has been reached.
In case of withdrawal of stakes from the liquidity pool, a withdrawing LP needs to burn its pool tokens to effect withdrawal.
Conclusion
Financial liquidity is the ability of an asset to be converted to cash, or the availability of cash anytime it is needed, anywhere. In the crypto environment, liquidity is referred to as the ability to enter and exit the market in all fluidity. It is a core technology in DeFi serving as its backbone to refine the space of tokens, smart contracts, lending, exchange, farming, payment gateways, and other novel financial instruments.
