- They play a significant role in the defi market by providing liquidity
- They are also very essential for yield farming and blockchain-based online games.
Liquidity pools play a very crucial role in blockchain technology. They are used in yield farming, synthetic assets, and blockchain gaming. Liquidity pools were built to maintain liquidity in the cryptocurrency ecosystem. The market can quickly achieve liquidity with the help of the order book, where the buyers and sellers of an asset place various orders. Which eventually decides the price of an asset. This leverage was not available in the cryptocurrency market. That’s the reason liquidity pools were built. Let’s first understand every detail of the liquidity pool by knowing its meaning.
What are Liquidity Pools?
Liquidity is essential for fast transactions; therefore, the blockchain community creates liquidity pools for processing fast transactions in the blockchain ecosystem. Hence, a liquidity pool is a collection of cryptocurrencies. This collection is made and locked with the help of smart contracts. These pools work with Automated market movers.
The users who use the liquidity pool are called the liquidity providers. These liquidity providers provide funds to the users for liquidity. In exchange for providing funds to the liquidity pools, these fund providers get fees which are called transaction fees. This fee is generated by the trades that happen in the pool.
The working of the liquidity pools
Liquidity pools work on the automated market maker mechanism. This mechanism is revolutionary. This mechanism allows for on-chain trading without the need for an order book.
So, as the name suggests, a liquidity pool is a pool of funds that are deposited by the liquidity providers or the users of the liquidity platform. Users get tokens for investing in the liquidity pool. This token represents the share of the user in the pool. This further determines the allocation of transaction fees in the pool according to the share of liquidity provided.
The liquidity pools provide traders with a golden opportunity to trade and swap different types of assets on the decentralised exchange. Liquidity pools contain treasuries; these treasuries are funded by people called stakers. These are the people who contribute two different types of assets to the pool, with a ratio of one volatile and one stable.
Once the stakes crowdfund the liquidity pool, the liquidity pool waits for the traders to arrive. Once the traders arrive at the liquidity pool to trade the assets. The liquidity pool allows him to trade the asset, and in return for trading the asset, the pool charges some transaction fees to provide liquidity to the trader. This fee is provided to the liquidity providers as a reward for providing their assets to the liquidity pool.
Advantages of the Liquidity Pool
These pools ensure that the decentralised exchanges and all the other lending platforms have the liquidity they require to function correctly.
Liquidity providers can also participate in the market because they can get decision-making rights and governance tokens, which will provide them with voting rights for the functioning of the pool. Anyone can access the Liquidity pool.
Top Liquidity Pools
Talking about the top liquidity pools, there are three pools that one can consider:
Uniswap: This is the most famous liquidity pool. Both in terms of popularity and in terms of trading volume. This pool allows decentralised trading between Ethereum and any other cryptocurrency.
Curve Finance: This liquidity pool is specially built for trading stablecoins. Since it only trades between stablecoins, it provides low volatility and low-cost swaps between different stablecoins.
Conclusion
Liquidity pools play a vital role in the blockchain ecosystem, providing essential liquidity for fast transactions and enabling decentralised exchanges and yield farming. They empower users as liquidity providers, offering rewards and governance tokens. Uniswap and Curve Finance stand out as prominent liquidity pools, facilitating seamless trading in the cryptocurrency market.
