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.
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.