One of the basic technologies used by DeFi is Liquidity Pools. These tools are an important yield farming part, blockchain gaming, automated market makers also called AMM, synthetic assets, and others that are still ongoing today.
Liquidity pools are funds that are collected digitally and become very large piles. Then what do you think if this pile continues to grow because someone is adding liquidity to it without permission?
If you want to know how DeFi works, then read this article to the end because we will give you the answer.
DeFi or Decentralized Finance managed to make a boom in on-chain activity. Even DEX volume can now compete on a centralized exchange. Even the data shows in December 2020, DeFi managed to lock 15 billion dollars in it.
Of course, the ecosystem continues to grow with various types of new products that you can now enjoy. It all starts with the core technology that creates liquidity pools.
What are Liquidity Pools?
As we mentioned above, liquidity pools are a collection of digitally stored and locked funds. Anything related to liquidity pools can be used for lending, facilitating decentralized trading, and other functions.
It can be concluded that liquidity pools are the center of many decentralized exchanges (DEX). Anyone can access liquidity and AMM has now made the market more accessible to everyone.
To collect liquidity, of course, there are protocols used, one of which is Bancor. However, there are other protocols commonly used by popular exchanges such as SushiSwap for Ethereum.
Liquidity Pools vs Order Books
After we know a little about liquidity pools, then we need to understand further between liquidity pools and order books. Because the two are different, although many people think they are similar.
Order books are a collection of orders that are opened with a specific market objective. In order books, there is a system that matches orders, namely a matching engine.
Different from liquidity pools, order books are the core protocol of a centralized exchange or CEX. This is what makes order books able to facilitate exchange and make it more efficient and make financial markets more complex.
Before we go any further, you need to understand that there is one DEX that works well using the on-chain order book. This DEX is Binance DEX or Binance Chain which is specially designed for cheap and fast trading.
One of the projects that you may know about is Project Serum which was built on the Solana blockchain.
How Liquidity Pools Work
The way liquidity pools work is because of AMM. Because they are a significant innovation to trade on-chain without order books. Because you will not get direct pressure when you want to trade.
Here you can consider peer-to-peer exchange of order books. This means that sellers and buyers will be associated with order books.
However, trading using AMM is certainly different from this, because AMM trading is called a peer-to-contract. As you know above, liquidity pools are funds that are digitally collected through smart contracts by all liquidity providers.
So when you trade on AMM then you will have no partners or partners in it. However, if you trade in liquidity pools, buyers can buy directly and don’t need sellers, only liquidity pools.
Purpose of Use of Liquidity Pools
Now that we know about the most popular AMMs in liquidity pools, the concept is very simple and you have several purposes for using liquidity pools.
One of the functions of liquidity pools is for agricultural produce. Because liquidity pools are the basis of all auto-generating platforms, for example, yearn. Yearn allows users to add their funds to a pool that can generate results.
Recently, the use of liquidity pools has become more sophisticated for tranching. Tranching is a concept commonly used in traditional finance that is useful for distributing financial products based on the risk and total return you have.
To mint blockchain synthetic assets, it also relies on liquidity pools. You can add some collateral to it and then connect it to a trusted oracle.
Liquidity Pools Risk
This time we will find out what the risks may be when deciding to trade in liquidity pools. If you choose to provide liquidity to AMM, then you need to know what non-loss concepts are.
If you choose to provide liquidity to AMM, then you are likely to suffer permanent losses, such as small or large losses. In addition to losses, another risk that you may experience is the risk of smart contracts.
when you deposit funds in the liquidity pools, the funds will be locked in the digital pool. Even if no middleman or person is holding your funds, these smart contracts can be considered custodians.
So when there are bugs or exploits such as flash loans, then most likely your funds can be lost and you are at a loss. You should also be wary of development projects that may be able to manage liquidity pools because they have permissions.
Because some developers have privileged access that can open smart contracts. Of course, this has the potential to be dangerous because they can take or control funds in the liquidity pools.
From all the information we provide, it can be concluded that liquidity pools are the core technology used in the current DeFi technology.
Liquidity pools allow you to decentralize trading, generate yields, make loans, and much more. Because with this smart contract, you can move every part of DeFi.
Therefore you have to be careful when choosing liquidity pools. Because many people feel disadvantaged because of funds that have disappeared permanently or are deceived by developers.
You should see reviews of the liquidity pools as well as the smart contracts that lock your funds. Because by looking for compatible liquidity pools, your funds can be safe in it even without a developer.
You need to be wary of developers who have special access to liquidity pools. Because they can easily manage and control your funds which leads to losses. Choose trusted and safe liquidity pools to trade.