The proliferation of on chain activities can be attributed to the rise of decentralized finance
or defi. The volume on decentralized exchanges is able to seriously compete with the volume on
centralized exchanges. There is a potential worth over $48 billion locked up in the protocols of
decentralized finance. The ecosystem is expanding at a rapid rate with the addition of new product
categories. But what is it that makes all of this growth feasible? The liquidity pool is one
of the fundamental technologies that underpins all of these different products. Disclaimer,
I'm not a financial advisor. The video is for informational and educational purposes only.
Hey everyone. Welcome to Crypto Trends. In today's video, we'll talk about water
liquidity pools and how do they work. So make sure to subscribe to the channel so
you don't miss out on any of our videos. So without further ado, let's get into it.
What is a liquidity pool? A liquidity pool is a collection of funds that have been locked up
in a smart contract. Liquidity pools are used to support decentralized trading,
lending and a variety of other activities. Many decentralized exchanges or decks such as unis,
swap, rely on liquidity pools to form a market. Users known as liquidity providers or LP combine
an equal value of two tokens in a pool. They earn trading fees on trades that occur in their pool in
proportion to their share of total liquidity in exchange for providing their funds. Amms
have made market creation more accessible because anyone can be a liquidity provider.
Bancor was one of the first protocols to use liquidity pools, but the notion gained traction
with the popularity of unis. Swap, sushi, swap curve and balancer are among more popular Ethereum
exchanges that leverage liquidity pools. These venues, liquidity pools contain e R 20 coins,
pancake swap, battery swap, and burger swap are B n b Smart chain BSC analogs with pools containing
b e p 20 tokens. Liquidity pools versus order books to understand how liquidity pools differ,
consider the order book. The fundamental building element of electronic trading simply explained The
order book is a collection of all open orders for a specific market. The matching engine is
the system that matches orders with each other. The order book together with the matching engine
is the heart of every centralized exchange or c E X. This paradigm is excellent for promoting
efficient interchange and for enabling the development of complex financial markets.
Defi trading, on the other hand, entails conducting trades on chain
with no centralized party holding the funds. When it comes to ordering books,
this presents a challenge. Each interaction with the order book incurs gas expenses, making trade
execution significantly more expensive. It also makes the task of market makers who offer
liquidity for trading pairs more expensive. Above all, most blockchains are incapable
of handling the requisite throughput for daily trading of billions of dollars. This means that
an on chain order book exchange is nearly impossible on a blockchain like Ethereum.
Side chains will layer two solutions, which are on the way, could be used. However,
the network cannot handle the throughput in its current state. Before we proceed any further,
it's important to note that some decks that operate quite well with on chain order books,
Binance decks is based on Binance chain and is specifically designed for quick and cheap trading.
Another example is Project Serum, which is being developed on the Solana blockchain. Nonetheless,
because so many assets in the crypto realm are on Ethereum, you can't trade them on other networks
unless you employ a cross chain bridge. How do liquidity pools work? Automated market
makers or a M m changed the game forever. They enable on chain trading without the use of an
order book. Because trades do not require a direct counterparty, traders can enter and exit illiquid
token pairs. Peer-to-peer order book connects buyers and sellers finance deck trades directly
between user wallets, making it a peer-to-peer exchange. Amm trading is distinct. Amm trading is
done contract to contract to construct a liquidity pool. Liquidity suppliers deposit funds into a
smart contract. Amm transactions lack a typical counterparty. You make your trades against the
liquidity pool. The buyer does not require a sale, only sufficient liquidity in the pool.
There is no typical seller when purchasing food coins on unis swap. Your activity is managed by
the pool's. Algorithm pricing is determined by this algorithm based on pool trades. If you want
to know more about amm, let us know in the comment section down below, and we would then definitely
make a video on it. So let's get back to the topic because a liquidity must come from somewhere. Your
counterparty might be anyone you engage with the pool's contract as opposed to the order
book notion. What are liquidity pools used for? The most common application of liquidity pools
is amms. Pooling liquidity is a simple concept that can be used in a variety of ways. Another
example is yield farming on platforms such as yearn users add cash to liquidity pools in order
to earn money. Crypto projects have a difficult time getting new tokens to the right individuals.
Liquidity mining is a successful strategy. Users that deposit their tokens in the
liquidity pool are automatically rewarded with tokens. New tokens are distributed
according to each user's pool. Share pool coins or tokens that originate from other
liquidity pools. You'll receive tokens if you supply liquidity to unis, swap,
oral lend funds to compound. You might be able to reinvest those tokens in a different pool.
Protocols can use pool tokens from other protocols with their goods making these
chains more complex. Another application is governance. In some cases, a large number
of token votes are required to propose. Formal governance members can help a protocol related
charity by pooling their funds. Another defi field is smart contract insurance. Many of its
implementations are powered by liquidity pools. Another novel application of liquidity pools is
transing. It's a traditional finance concept that categorizes things based on their risk and return.
With these products, LPs can change the risk and return characteristics. Liquidity pools are used
in synthetic asset mining. On blockchain, a synthetic token can be created by providing
collateral to a liquidity pool and connecting it to a reliable oracle. In reality, it's more
complex, but the concept is straightforward. What remains the ingenuity of defi? Developers will
uncover many more possibilities for liquidity pools, the risks of liquidity pools. If you
provide liquidity to an A M M, you must understand IM permanent loss. You lose money when you give
amm liquidity versus hobbling, you risk losing money. If you offer liquidity to an amm. Sometimes
it's small, sometimes it's big. Remember, the risks of smart contracts deposited funds
are placed in the liquidity pool. Even though there are no middlemen, the contract itself is
the custodian of your funds. Your money could be lost if a flash loan contains a flaw or exploit.
Be wary of programs where developers have the ability to change pool rules. Administrator keys
or privileged access to smart contract code may be granted to developers. This could enable them
to take pool funds. Defi is rife with rug pools and exit scams. Final thoughts. Liquidity pools
are a key component of the current defi technology stack. They enable decentralized trading, lending,
yield creation, and a variety of other activities. These smart contracts fuel nearly every aspect of
defi and will almost certainly continue to do so. So do you know about any other
uses of liquidity pools? If so, please let us know in the comment section down below.
With that being said here, we come to the end of our video. I hope you like this video, and if so,
then don't forget to subscribe to the channel so you never miss any
video. See you in the next video. Till then, take care. Thanks for watching.