What is a Liquidity Pool? It is a new automated way to deal with the liquidity dilemma of decentralized exchanges, and the DeFi liquidity pool was born in due course. They replace the traditional order book approach, which is directly adapted from the established financial system and adopted by centralized cryptocurrency exchanges. So, what exactly is a liquidity pool? How does it work? Below, let’s take a look.
What is a Liquidity Pool?
The liquidity pool is basically an ordinary pool of funds used to apply to given market transactions.
When it comes to liquidity pools, everyone thinks of two concepts, liquidity and capital pools.
Liquidity refers to the status of enterprise and enterprise liquidity. Liquidity is the manifestation of current assets, that is, the total assets that can be realized or consumed by an enterprise or enterprise within a production cycle of one year or more than one year.
Broadly speaking, working capital refers to all current assets of the company, including cash, inventory (materials, work in progress, and finished products), accounts receivable, securities, advance payments and other items. Businesses related to virtual currencies also include cryptocurrencies.
Liquidity is also known as operating liquidity. In a narrow sense, working capital = current assets – current liabilities, the so-called net working capital.
The other is the fund pool, Cash Pooling, which literally means pooling assets together to create a space for storing assets like a storage pool. The fund pool was originally a fund management model jointly developed by the financial company of the multinational company and the international bank, to uniformly allocate the group’s global assets, and minimize the net position held by the group. The cash pool business mainly includes issues such as transfer of the balance of the leading group, daytime overdraft of member companies, active appropriation and collection of funds, entrusted loans between member companies, and member companies’ deposits and loans to the group headquarters. Interest calculations, etc. .
The capital pool of enterprises related to blockchain and cryptocurrency can be used for business operations, and most customers can also participate in it. Users can profit from it and can withdraw it at any time. The method of funding can be either cash or related cryptocurrencies.
However, hackers steal coins frequently in the field of cryptocurrency, and the security of cryptocurrency is affected. There are also cryptocurrencies themselves that are highly volatile, and their value is easy to drop.
Therefore, companies in the cryptocurrency field must take security measures and countermeasures at the liquidity pool level to ensure the normal operation of the company.
Pros and Cons of advantage:
1. Simplify DEX transactions by executing transactions based on real-time price quotes.
2. Allow everyone to provide liquidity to their cryptocurrencies and receive rewards, interest or annual rate of return.
3. Apply publicly visible smart contracts to maintain transparency of security audit information.
shortcoming:
1. The pool of funds is controlled by a single group, which goes against the concept of decentralization.
2. The risk of hacking due to poor security protocols will cause losses to liquidity providers.
3. Risk of fraud, such as blanket pulling and export fraud.
4. Suffering from impermanence. This happens when the price of an asset locked in your liquidity pool changes and results in an unrealized loss, rather than when you just store your property in your wallet.
How does the liquidity pool work?
The most basic form of a DeFi liquidity pool is to store 2 currencies in a smart contract to establish a trading pair.
As an example, let’s use ether (ETH) and dollar coin (USDC), where the price of ETH can be expressed as 1,000USDC. Because the liquidity provider puts equal amounts of ETH and USDC into the pool, 1 ETH must be matched with 1000 USDC.
Because of the liquidity of the mining pool, users can immediately use their deposited cash to exchange ETH for USDC without having to wait for counterparties to match their orders.
Liquidity providers receive rewards for their contributions. A new currency, called pool currency, embodies their input when saving. The pool currency in this image will be USDCETH.
All liquidity providers will automatically receive a certain percentage of transaction fees charged by users of the application pool swap currency, which is proportional to their equity level.
Therefore, if liquidity providers bring in 10% of the pool, and the transaction cost of the USDC-ETH pool is 0.3%, they are entitled to 10% of the total transaction volume of 0.3%. Burning their pool currency allows users to claim their stake in the liquidity pool whenever they want.
Speaking of which, I believe everyone has a certain understanding of what a liquidity pool is and how it works. In general, the liquidity pool is one of the key technologies of the current DeFi technology. They do decentralized trading, borrowing, profit generation, and more. These smart contracts can empower almost every aspect of DeFi, and are likely to continue in the future.
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