What are liquidity pools? Without liquidity, modern finance… | through TheStandard.io’s DeFi protocol

Modern financial systems could not function without liquidity. In decentralized finance (DeFi), the concept of liquidity was implemented in the form of pools. What are liquidity pools? How do you work? And how do they relate to decentralized finance (DeFi)?

In this article you will get answers to these questions in the simplest terms.

What is a liquidity pool?

A liquidity pool is a vault where market participants pool their assets to collectively provide a comprehensive supply of liquidity to anyone wishing to trade assets. In a traditional financial system, large banks act as a pool. They manage the funds of different depositors and can even “print” additional money.

A cryptocurrency liquidity pool is the inventory of tokens locked in a specific smart contract account. They are used to support trading activities (trading) and are heavily used by decentralized exchanges (DEXs).

One of the first projects to introduce the concept of a liquidity pool was the Bancor project. However, it was the Uniswap project that popularized the concept of the liquidity pool.

How do liquidity pools work?

In its basic form, a liquidity pool contains two tokens, creating a new foreign exchange market for these assets.

When a new pool is created, the first liquidity provider sets the starting exchange rate for assets within the pool. Each provider must deposit an equal number of both tokens into the pool. Suppose the initial exchange rate within a pool differs from current global prices. In this case, an arbitrage opportunity arises immediately, which could result in a loss of capital for the liquidity provider. This concept of providing tokens in the right proportion remains valid for all subsequent providers who want to lock their funds in a pool.

After sending tokens to a pool, the provider receives unique tokens (LP tokens) – proportional to the provided liquidity. When a transaction takes place using such a pool, the decentralized exchange charges a commission of 0.3% of the transaction. This commission is distributed to each participant in the pool in proportion to their share. A return is therefore due for each provision of liquidity. If the provider wants to return the invested funds from the pool (including the accrued earnings), it must destroy its LP tokens.

Each token exchange that occurs with the help of a liquidity pool causes the exchange rate to move according to a special algorithm. This mechanism is called Automatic Market Maker (AMM) and liquidity pools of different protocols may use slightly different algorithms.

Simple liquidity pools like Uniswap use a constant calculated as the product of the amount of both tokens in the pool. The pool can thus provide liquidity at any time. Put simply, the fewer A tokens there are, the more expensive they become and the cheaper B tokens become. It turns out that someone who buys a lot of ETH in the pair ETH/DAI reduces the supply of ETH and increases the supply of DAI, which is immediately reflected in the exchange history. The larger the volume of the pool relative to the size of the transaction, the less impact that transaction will have on the price.

Large pools of liquidity create a more stable environment where each trade has little impact on exchange rate movement. This is the ultimate goal of market participants and liquidity providers (remember, they earn commissions from transactions, so more transactions result in more revenue). Because of this, protocols like balancers have started encouraging liquidity providers to invest their tokens in specific small pools in order to “swing” them. This process is known as liquidity mining.

What are liquidity pools used for?

If you’re already familiar with crypto exchanges like Binance or CEX.io, you probably know that trading activities are conducted through an order book.

Buyers want to buy an asset at the lowest possible price. Sellers, in turn, want to sell at the highest possible price. In order for transactions to take place, buyers and sellers must agree on a “fair price”. As a result, either the buyer is willing to pay more or the seller agrees to sell for less.

But what happens if none of the market participants are willing to change their expectations? Or if there are not enough tokens to fulfill an order? This is where market makers come in.

Market makers are larger players who support trading activity through their willingness to buy or sell any amount of a given asset (“any” – meaning big enough for most players). Of course, their “fair price” is always slightly skewed in their favor. They work in a similar way to an exchange office: due to the “spread” between the buying and selling rate. Thanks to the existence of market makers, you don’t have to wait for a seller to appear for the asset you want to buy. the same applies vice versa.

The main problem is that the order book model relies heavily on having a market maker (or multiple) for each asset. Without market makers, the exchange immediately becomes illiquid and inconvenient for ordinary users. None of us are used to waiting hours for the possibility of an exchange. In addition, market makers are constantly changing their exchange rates by creating and closing orders on the ledger. Supporting this type of activity would result in a heavier traffic load on a blockchain, for which end users would pay a higher fee. Again, everything would be slower. For example, the Ethereum blockchain, with its current throughput of 12-15 transactions per second, simply could not support such a model.

The problem with the order book model has long been a concern for cryptocurrencies. On the one hand, this has led to the development of alternative, faster blockchains such as EOS. On the other hand, projects like LoopSpring plan to build a Layer 2 infrastructure for Ethereum.

The most successful concept to date has been the complete abandonment of the order book. This led to the emergence of decentralized liquidity pools.

What is crypto liquidity pool farming?

Liquidity farming is a concept in decentralized finance (DeFi) where cryptocurrency assets are placed in a liquidity pool to receive more cryptocurrency in the form of interest. The smart contract manages the liquidity pool, and the users who deposit or invest in cryptocurrencies are called Liquidity Providers (LPs).

Liquidity farming works like regular investing, where you invest in a platform to make money over time. However, in this case you are using digital assets or currencies instead of traditional currencies. As a result, the returns you receive from your cryptocurrency liquidity are higher than what you would normally receive from a savings account.

Finally

TheStandard.io offers users the opportunity to earn high returns by purchasing liquidity bonds. These bonds are purchased with your newly minted sEURO paired with USDC and pay out initial value plus yield via native governance token The Standard Token (TST). These unique high-yield bonds can be easily purchased and redeemed through TheStandard.io user interface or by directly interacting with the smart contracts on the blockchain.

The standard allows you to mint your first stablecoins at a discount, generate quick returns by helping build a secure protocol, and provide liquidity for the protocol’s first stablecoin, the sEURO.

Add your sEURO to the protocol liquidity pool for a generous return.

How to get involved

Don’t miss our first coin event and mint sEURO for instant returns.

Visit https://app.thestandard.io now to get started!

For those who have already received your TST rewards from Phase 2, you can now use your TST in Phase 3 of our Initial Minting Event for sEURO! Go to https://app.thestandard.io/stage3 to get started.

For more information on how the IBCO works and instructions on how to do it, visit thestandard.io.

Finally, join our community on Discord if you have any questions or need support for the project! https://discord.gg/thestandard-io-836907456743079956

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