LIQUIDITY POOLS EXPLAINED
Liquidity Pool is one of the core technologies that make the expansion of Decentralized Finance (DeFi) possible. About 21 billion dollars of value are locked in DeFi protocol as of Dec 2020.
Liquidity pool is an integral part of DeFi borrow-lend protocols, Automated Market Makers AMM), blockchain gaming, etc. With the aid of a liquidity pool, trading is facilitated and made easier.
What is a Liquidity Pool?
Liquidity Pool is a pool of tokens locked in a smart contract. They are used to facilitate trading by providing liquidity. Liquidity pool is extensively used by Decentralized Exchanges (DEXES). In a liquidity pool, users normally referred to as liquidity providers (LP) add an equal amount of two tokens to create a market, and in return, they are rewarded with trading fees for any transaction that happens in their pool.
This reward is proportional to the share of the total liquidity they provided.
One of the first projects that introduced a liquidity pool was Bancor which was popularized by UniSwap. Other Exchanges that use this concept in Ethereum Blockchain are SushiSwap, Curve, and Balancer. While on the Binance Smart Chain, we have PancakeSwap, BakerSwap, and BurgerSwap. In the Ethereum chain the pool contains ERC-20 tokens while in BSC, the pool contains BEP-20 tokens.
Why Do We Need Liquidity Pools?
Before delving into the working principles of liquidity pools, it will be necessary to understand why we need them in the first place. Let’s go!
In platforms like Binance and Coinbase, trading is based on the Order Book Model. What the order book model does is simply match orders from buyers and sellers in a given market based on set rules. Buyers and sellers come together and place their orders. The buyers try to buy at the lowest price possible while the sellers try to sell at a higher price. For a trade to take place, the two parties must converge at a particular price. This is made possible either by the buyer bidding higher or a seller lowering his price.
But in a situation like this, what if both parties refuse to make progress? What if no one is willing to adjust his price? Ok even if the price converges, what if the seller doesn’t have enough of what the buyer needs? What happens then? This is where market makers come into play. So with the aid of a market maker, the buyer/seller doesn’t always need to wait for another party to show up before they can carry out their trade. Did you get the gist? Ok, let’s make progress.
Let’s use this scenario to understand better. James and Andrew are traders. James, in this case, wants to purchase $500 worth of a token, Andrew is willing to sell his token, but he doesn’t have enough to meet James' demand. For a trade to occur here, either James goes with what Andrew has at an agreed price or the trade will not take place. So in a situation like this, we need someone with enough of the token to sell to James and at the same time be willing to buy from Andrew. And in this case, we refer to this person as a market maker.
So market makers facilitate trading by providing enough liquidity at any point in time. With a market maker, James and Andrew will be able to trade without waiting for each other to show up. We can also refer to these central entities as life market makers. You get it now, right? Ok, let’s continue.
We can try to reproduce this same model in DeFi. But then using this approach might be slow, expensive, and result in poor user experience. DeFi requires executing a trade without any central entity holding the fund as in the case of the order book model.
Order Book Model solely depends on a market maker or market makers. Without them, there will be no exchange. Also, market makers will have the sole power in adjusting prices which may be unfavourable for traders. Using the order book model in a blockchain like Ethereum where every transaction requires a high gas fee, also makes the job of a market maker extremely expensive.
Since DeFi requires no central entity before executing a trade, there comes the need for a liquidity pool. Traders will need to interact with the algorithm that governs the pool and not any person in particular. And this algorithm is secured by a smart contract. In this situation now, we can comfortably say they are interacting with an Automated Market Maker (AMM). So to facilitate automated market making, we need a liquidity pool. With that in mind let’s look at how liquidity pools work.
How Do Liquidity Pools Work?
A liquidity pool holds two tokens, each pool set up creates a new market for that particular pair. WETH/USDT and USDC/USDT are common liquidity pools that can be found on UniSwap.
When a new pool is created, the first liquidity provider sets the initial price in the pool. He is incentivised to supply an equal value of both tokens in the pool. This is also the same for all liquidity providers that are willing to add to the pool. When liquidity is supplied, the liquidity providers receive a special token known as Liquidity Pool tokens. The liquidity pool token received will be proportional to the liquidity supplied. So whenever a liquidity provider wants to get back his funds, the liquidity pool token must be destroyed.
When any trade is carried out in a pool, about 0.3% of the fee is distributed among the liquidity providers according to the liquidity provided.
So with the aid of a liquidity pool, James and Andrew will be able to carry out their trade smoothly without any third party or life market marker. This concept can be referred to as Automated Market Maker (AMM). When James wants to purchase any coin, there is no need for Andrew, rather his activity will be managed by algorithms that govern the pool. That is the essence of DeFi.
The prices of tokens in the pool are also determined by the trades that take place in the pool. To understand better how this algorithm works, I suggest you take a look at the AMM guide. The concept behind liquidity pool and Automated Market Maker (AMM) is quite interesting and powerful as we don’t need to rely on any central book or external market markers to keep providing liquidity. Using AMM can be seen as interacting with a smart contract while the order book model can be seen as peer-to-peer, just like trading on Binance.
Potential Risks of Liquidity Pool.
Any liquidity provider or intended liquidity provider needs to be aware of the risks involved such as Impermanent loss, Admin keys and Smart contract bugs.
Impermanent loss occurs when you provide liquidity to a pool and the initial price of the token in the pool diverges from the current global market price. This can lead to loss of capital on the part of the liquidity provider.
Also before providing liquidity, you need to do thorough research into the projects you are getting involved with. In some cases, the developers do have an admin key within the smart contract code. With this key, they can manipulate the pool and perform some criminal activities. I encourage you to go through this article DeFi scams. It will enable you to avoid rug pulls and be able to know when to exit a scam pool.
Another thing to bear in mind while providing liquidity is smart contract bugs. You know fully well that no one is in control of your funds, so technically speaking there is no middle man. Your fund is at the mercy of the smart contract. So if there is any bug or hack on the smart contract, that means your money is gone and gone forever.
With the emergence of liquidity pools and AMM, trading is smoothly carried out. Traders can jump from one trading position to another without any obstruction. It has provided a great platform not only for the traders but for the liquidity providers who have the opportunity of earning through providing the needed liquidity to the pool.
One of the reasons I decided to pinpoint this topic is for a project called Glitch_Guild...
What is Glitch_Guild.
For those who has not been following me for a while now...
Glitch Guild - is a decentralized autonomous organization (DAO) aimed at fair distribution of resources and functioning through
the efforts of community members.
The Guild seeks to reward participants not depending on their financial contribution, but on their positive impact on the development of the guild. An important aspect is the direct participation in the growth of the Knight ecosystem on the BNB smart chain. Bringing value both financially and building a strong community that will help the project grow faster.
According to the whitepaper...
Glitch Guild's goal is to maximize the value of NFTs collection and education through research activities. One of the main goals is to find talented people and researchers for grants and incubation of NFT projects.
Building a global community of NFT collectors Support for novice artists, programmers, researchers,
gamers. Coordinating research for new partnerships;
Allow the community to participate in the drawing of tokens of projects in which the guild has invested
by holding NFTs, accepting proposals and voting Producing revenue through
sale of GLITCH NFTs and incubated NFT projectsBuilding a global community of P2E gamers;
Building a global community
of researchers;
Glitch_guild liquidity
As you have learned what liquidity is all about and who is responsible for adding liquidity, glitch_guild has a well planned liquidity, which will help the project and community members. On glitch_guild tokenomics, the the percentage reserve for liquidity pools is 14%.
As quoted on the whitepaper "Another part of tokens is needed to form initial
liquidity on PancakeSwap and KnightSwap so people can buy tokens from these two exchanges and help develop the project". As you can see this is to enable the token to be tradable when launched on pancakeswap and KnightSwap and other platforms in the future....
But this is not the only thing good about this amazing project, there are many interesting things to know and understand.
more information about this can be found on their whitepaper. Follow my page for more interesting articles.
Whitepaper
MAIN CHAT
ANNOUNCEMENTS
TWITTER
MEDIUM
#glitch_guild #glitch #defi #blockchain #bnb
