As the field of DeFi develops, it will become increasingly important to understand the deeper details of Decentralized Financial Services, which is why we are reviewing the operation of liquidity pools today. The term is known in English as a liquidity pool, it is something that is essential in the field of various decentralized exchange services, i.e. DEXs (Decentralized Exchanges). Let's hit it!
On DeFi exchanges (DEX), community members provide the capital reserves needed to operate
A decisive and even essential element of classical stock exchanges, but even of cryptocurrency stock exchanges, is to have a sufficient amount of capital, i.e. liquidity, in the system. After all, if this is not the case, the system will not work, the supply and demand will find each other in vain if there is not enough capital to be able to serve all parties involved at all times.
An important concept is the so-called order book, this is the list of records that records intentions to buy, aligns them with intentions to sell. This is also something that exists in the world of both classical and cryptocurrency exchanges. However, in the case of a decentralized cryptocurrency exchange based on smart contracts, there is no central capital reserve provided by the operators, but liquidity is needed in the same way as for all other types of exchanges.
Liquidity pool, the smart contract
To solve this problem, DEXs use smart contracts, which ensure that the paid-in capital will be used for the specified purpose, i.e. to smooth the trading of the stock exchange. But where does the capital come from? Of course, from the community, anyone can invest, anyone can place their crypto money in a smart contract, thus contributing to the operation of a DEX.
Contributors, more specifically investors, are, of course, rewarded, which is, of course, nothing more than some kind of cryptocurrency. The amount of the payment, ie the reward, is directly proportional to the amount of our payment, the more capital we contribute to the maintenance of the system, the more rewards we can receive.
ETH vs USDC
Let's look at a specific example. Suppose someone wants to buy USDC, or more accurately, trade for ether. In order for this transaction to take place, USDC is definitely needed in the system. The solution is that among the liquidity pool uploaders there should be someone who gives ETH and also someone who gives USDC. This is because this trading step has to work in both directions, whether someone wants to buy USDC for ether or vice versa.
That’s why it’s important to have someone who puts in both the ether and the equivalent of $ 1,000. This is essential because if someone comes who has an ethereum for which they want to get USDC, they would have to wait until someone comes with a USDC and wants ethereum to face it without filling the liquidity pools. stand for the two transactions.
Matching supply and demand is the essence of any marketplace, if it is not given, it will become meaningless, at least its functionality will be significantly impaired, and users will be disappointed, which is not good for anyone.
Why would anyone contribute to the operation of a DEX?
The question rightly arises as to why anyone still contributes their hard-earned crypto money to the life of a DEX, the answer is very simple. Rewards are placed for those who place their coins in a smart contract created for this purpose, the rate of which varies, but is generally ten percent.
For example, if the trading commission is 0.3%, we get 10% of that. This may not seem like a particularly significant amount at first, but let’s not forget that if a DEX, provided it is successful, operates a large number of trades, we receive our commission after each trade, in which the capital we place played a role. Accordingly, we can still do well, we can achieve nice additional income.
Finally, we need to add that a liqudity pool can carry a number of risks, we need to be sensible when choosing who exactly to entrust our capital to. It is important to follow the given DEX thoroughly, read as much as possible about them. We also need to be aware that this market, and accordingly technology, is still in its infancy, so problems with a smart contract or a possible attack can cause headaches, we can even lose all our kiptopos. So let’s be careful when choosing DEX and a liquidity pool for ourselves!
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