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What is a liquidity pool in DeFi yield farming?

What is a liquidity pool in DeFi?

As the name suggests, a liquidity pool is a pool of tokens locked in a smart contract. It facilitates transactions in a DeFi protocol. Additionally, 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 generally very similar to the concept of pooled funds, which existed long before that. Put simply, it’s like a reservoir formed by pooling funds. Liquidity pools are basically the same, except 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 a trade can move the price significantly in any direction, making the market unpredictable and unattractive. Liquidity pools are an integral part of the DeFi revolution and seem to have huge potential. Typically, these pools facilitate the exchange of large numbers of assets for other supported assets.

If you have used a cryptocurrency trading platform, you should know that the platform’s transaction 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 asset they want at the lowest price, while sellers want to sell the same asset at the highest price. Therefore, the buyer and seller must agree on a price if a deal is to be completed. Two things can happen in a transaction: the buyer increases their bid and the seller sells at a lower price.

But what if nobody is willing to bid again? Or what if you don’t have enough funds 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 by 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 difficult to use, but without market makers an exchange would become illiquid immediately. Therefore, now is the time to invent something new to make it work more smoothly in a decentralized world. For this reason, liquidity pools are needed.

How does the liquidity pool work?

In general, a liquidity pool has two tokens, and these two tokens form a new market transaction. When a new liquidity pool is created, the first liquidity provider (LP) sets the initial price in the pool and that LP is caused to maintain the same value for both assets in the pool.

Credit: coinsutra

When the liquidity pool receives liquidity (which can be understood as a capital injection), LP receives a special LP token that represents the liquidity ratio they provide. When this liquidity pool facilitates transactions, 0.3% of transaction costs are shared among all LP token holders. If LPs wish to withdraw the liquidity they provide, the LP tokens they represent must be burned.

Each time LP tokens are burned, 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 two given tokens remains constant. In addition, due to the algorithm, the pool will still remain 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 balancers, are starting to give LPs more incentive to attract liquidity. This process is known as liquidity reduction. The concepts of liquidity pools and automated market makers are simple but useful. If we don’t have a centralized order book, we don’t need external support from market makers.

Introducing yield farming opportunities

CrowdSwap adds new yield farming programs for different chains. Previously, users could farm on Polygon and BSC networks. Each of these blockchains has different options, to which new ones will be added as the system is updated. So far, the following pools are accessible on CrowdSwap:

BNB smart chain polygon

Joining these pools is done on CrowdSwap with very simple steps that anyone can follow. The interesting thing about yield farming options on CrowdSwap is that cross-chain technology allows asset holders from other chains to participate in these programs. This means you don’t have to exchange your existing tokens for the LP pair before investing. Check out these standout features and more by visiting the POSSIBILITIES section of the CrowdSwap app.

How Much Can You Earn With Liquidity Pools?

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

last words

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

Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers

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