The crypto market is constantly evolving, and since bitcoin was created 13 years ago, a lot has changed. In the last two years, decentralized finance (DeFi) has become one of the most talked-about topics for those investing in crypto assets.
Before understanding what liquidity pools are, it is necessary to understand the concept of DeFi. Decentralized finances are projects and tools that have been created to support the digital economy by performing tasks known in the traditional financial market.
Through DeFi projects, lending, transaction, and token issuance protocols have come to life in the crypto market, for example. As the term implies, these platforms are known for their decentralization of data.
The DeFi concept has also enabled the creation of liquidity pools. The ‘pools of liquidity’ is a figurative term that expresses the allocation of crypto assets in a data validation protocol on a blockchain network.
Now that you understand more about DeFi, let’s get into the details of the liquidity pools.
What is a liquidity pool?
The term liquidity pool is intrinsically linked to a consensus mechanism for validating information on a blockchain network known as proof of stake (PoS). It is through this location, which groups tokens and crypto assets, that transactions and smart contracts can be validated.
In practice, pools provide liquidity for blocks of data generated using the proof of stake protocol. It is by using the balance within these ‘pools’, that networks like Ethereum can validate transactions and smart contracts.
Unlike data mining activity, which uses the proof of work (PoW) mechanism, liquidity pools waive the miners and serve as a support for the proof-of-stake protocol.
In addition to providing liquidity for blockchain networks that use the PoS mechanism, liquidity pools can be used by DeFi tools, decentralized applications (D’Apps), and even decentralized exchanges (DEX).
What is the purpose of a liquidity pool?
The primary purpose of a liquidity pool protocol is to provide enough balance for a platform to validate its transactions on the network. Thus, a liquidity pool becomes critical to the survival of these projects, which are integrated with proof-of-stake mechanisms.
Liquidity pool platforms only use crypto assets and tokens that are stored on them. For blockchain networks, this concept validates transactions and smart contracts and ensures the generation of new data blocks.
On the other hand, liquidity pools can represent a type of investment for users. Similar to mining, where the miner receives a reward for his work, in the liquidity pool, the holder of the tokens and crypto assets receive this kind of reward for providing liquidity for decentralized finance projects.
How does a liquidity pool work?
One of the biggest challenges for projects in the crypto market is ensuring full liquidity for their network. Liquidity pools were designed to meet this demand by providing liquidity to the network through tokens and crypto assets allocated by third parties.
Most of the time, a liquidity pool represents a crypto asset trading peer in the market. Therefore, you can only provide liquidity to the platform if you have the tokens represented in that trade type.
For example, in a liquidity pool between bitcoin (BTC) and tether (USDT), the user must deposit both crypto asset tokens in a 50/50 ratio. After that, he will receive tokens from the pool’s liquidity provider.
But, the reward for ‘lending’ your balance to the platform can be paid out in another type of token. In the case of using a liquidity pool of the decentralized exchange SushiSwap, for example, the user will receive the reward in sushi (SUSHI).
What are the pros and cons of a liquidity pool?
The liquidity pool offers more autonomy for decentralized platforms. The balance held by users waives data centralization and third-party control of the protocol.
Therefore, transactions tend to happen normally, without any supervision. As such, liquidity pools can be faster when processing data on the network, ensuring more liquidity for crypto projects.
Liquidity pools also represent more security and autonomy for blockchain networks. Almost all of them are created from smart contracts, which are public, and anyone can access them.
Even betting on data decentralization, liquidity pools are still controlled by a group of users representing the funds allocated there, which would be one of the reasons against this type of data validation.
Furthermore, the lack of centralized management can be a vulnerability exploited by criminals, known as hackers. Any failure in a liquidity pool can expose users’ balances to cyber attacks.
Liquidity pools can still suffer from fraud by their own creators, where scams such as ‘carpet pulling’ and ‘exit’ are common. In the rug-pulling, the project developer unveils itself as a scammer, withdrawing the funds in the protocol.
In the exit scam, the developer of the liquidity pool hopes to attract the balance of investors and then abandon the project, withdrawing all amounts before announcing the fraud.
On which platforms are liquidity pools available?
The tokens stored in liquidity pools are known as ‘total value locked’ (TVL). Currently, more than US$220 billion worth of crypto assets and tokens are stored in these pools.
Liquidity pools are used on virtually all DeFis platforms. A decentralized exchange, for example, would not function without this mechanism since it does not rely on an order book like a centralized exchange.
In addition to DEXs, blockchain networks can be powered by liquidity pools. This is the case with the Aave protocol, for example. These are smart contracts that determine where they will be used.
Finally, decentralized apps are other platforms that need liquidity pools. dApps can either have their own ‘crypto assets pool’ or also maintain integration with another platform, which provides liquidity using these pools with tokens and crypto assets.
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