One of the primary technologies underlying the Decentralized Finance (DeFi) protocols is liquidity pools. A liquidity pool is an accumulation of liquidity formed by funds locked in smart contracts. Liquidity pools are used for decentralized lending and borrowing. In addition, investors who provide liquidity to the pools can earn passive income.
What Is Liquidity?
Liquidity is the measurement of the ability to sell or exchange an asset quickly and without losing its value. In other words, liquidity is a measure of how easily an asset can be converted into cash. Assets that are more difficult to sell are called low-liquidity assets or non-liquid assets. The most liquid and therefore the most easily transferable asset is cash.
What Is a DeFi Liquidity Pool and How Does It Work?
The functioning of Decentralized Finance is heavily dependent on liquidity pools. Users who want to earn passive income stake their assets as cryptocurrency to the respective platform. Thus, investors provide liquidity to the system and are rewarded for it. As a result, liquidity is provided on the platform, which allows for faster trading. The liquidity pools solve the liquidity problem on the platform by incentivizing investors. In short, a liquidity pool is a digital supply of cryptocurrency secured by smart contracts. Assets on DeFi platforms are usually priced according to an algorithm. Besides, there are DeFi platforms that use order books like traditional exchanges. Automated Market Makers (AMMs) are important components of liquidity pools. AMM is a protocol that prices assets. It is an algorithm that enables automatic exchange of cryptocurrencies without any permission, with the assurance of smart contracts.
It allows users to earn passive income in exchange for providing liquidity and staking cryptocurrencies.
Many of them use smart contracts in a decentralized way that everyone can see.
The pool of funds may be under the control of small groups, contrary to the decentralized structure.
Due to weak security protocols, there may be security vulnerabilities that can cause losses for liquidity providers.