Market veterans are hesitant to enter the market unless liquidity is sufficient. They know something the rest don’t.
DeFi is booming for many reasons. One of the more important factors behind this boom has been the development of the concept and the emergence of decentralized liquidity pools.
The decentralized liquidity acts as a backbone in refining DeFi space more convenient and efficient. When provided from a wide range of parties whose behavior is deeply uncorrelated, liquidity is fundamentally more robust: it is less likely to evaporate in a crisis and more indicative of a healthy market. Therefore the health of DeFi is largely identical to the health of decentralized liquidity venues.
Decentralized liquidity provisioning is emerging through a mechanism that does not exist in traditional financial markets — automated smart contracts. This is a totally new vector of provisioning liquidity.
What are 2100NEWS DeFi liquidity pools?
Liquidity pools, in essence, are pools of tokens that are locked in a smart contract. Contracts are simply pools of 50% ETH and 50% CETF Tokens. They are used to facilitate trading by providing liquidity, so the users can always trade and they don’t have to wait for another counterparty to show up. There are two players in pool trading. The exchangers, who use the pools to exchange tokens, and the liquidity providers, who offer their liquidity to the exchangers. They earn exchange fees whenever exchangers make use of their liquidity.
Traders buy either asset directly from the contract, causing the prices to move algorithmically. When differences emerge between the algorithmically-determined price offered by the contract and the market price, arbitrageurs close the gap.
Uniswap liquidity pools use a constant product market maker algorithm that makes sure that the product of the quantities of the 2 supplied tokens always remains the same. A pool can always provide liquidity, no matter how large trade is. The main reason for this is that the algorithm asymptotically increases the price of the token as the desired quantity increases. The mechanism through which the price adjustments are made for each token swap on the liquidity pool is termed as Automated Market Maker (AMM).
Whenever someone trades on the exchange, the trader pays a 0.3% fee which is added to the liquidity pool. Since no new liquidity tokens are minted, this has the effect of splitting the transaction fee proportionally between all existing liquidity providers.
Anyone can replenish liquidity in the contracts by contributing liquidity to the pools, he would have to add both CETF Tokens and ETF at their current ratio to the Uniswap exchange contract, to maintain the same price for the trading pair. In return they are given tokens from the exchange contract which can be used to withdraw their proportion of the liquidity pool at any time. . This concept of supplying tokens in a correct ratio remains the same for all liquidity providers that are willing to add more funds to the pool. Doing so entitles them to a pro-rata share of the trading fees (0.3% per trade) that accumulate in the contract. The crypto users who stake or store their assets in these liquidity pools to yield more assets or income through the concept of DeFi Yield Farming are known as a liquidity provider.
The interest in Uniswap could be very high for some trading pairs. The yearly interest of 30+% is not necessarily a rarity. But how can it come to such high-interest values?
- the field is fairly new, and many still don’t know what liquidity pools are or how high the interest is.
- Furthermore, providing liquidity comes with risks, since it’s still new and prone to mistakes. A larger mistake in the code could mean total loss for users.
- Pool trading has advantages when compared to CEXs, all the tokens can be listed fairly easily, there is no KYC requirement and the costs are low when not considering transaction fees. Therefore, many trades on pool trading platforms which generates high interest in the form of fees.
This interest should in theory adjust over time and drop significantly since more investors will want to use them to generate fees. With more liquidity in the pools, the interest rate falls, since the collected fees will be divided on more staked capital.
Key Advantages of Liquidity Pools in DeFi
- Provides and bootstrap liquidity Providing Network
- Reduces Liquidity Risks in decentralized finance.
- Liquidity Providers earn passive income