By Larry Wright
Introduction
The crypto market has presented the end investors with tons of opportunities to invest their money and get feasible returns over the years. But the model is somewhat shaky and on the bleak side of being extremely volatile, which means that any and all investments that you have made within the crypto market are subject to pretty heavy losses if the market takes a bad turn.
It doesn’t matter in which manner have you invested your money, but at the end of the day, if it is invested in the crypto market or tied with it by any chance, then it sure is subjective to some notion of volatility.
If you invest in Bitcoin or any other cryptocurrency, you might be able to sustain pretty incredible returns on your initial investment, but at the end of the day, you would have to tackle the volatility factor. Another sub-branch of the crypto market and blockchain technology is decentralized finance. It allows personnel to have a direct approach to the crypto market and all the extreme features and opportunities that it presents the end investors with.
Given the bad reputation that the crypto market enjoys with all of its offerings, you might be pretty confused about the prospect of digital finance or decentralized finance and might consider it to be a part of that bad infrastructure.
But in reality, it is much more elegant than that, and all the offerings of decentralized finance are pretty standardized. What it does is that it lends the power of blockchain technology for the sake of powering its huge infrastructure in real-time and enjoying tons of Security benefits that the centralized business model is reluctant to do so.
Decentralized finance has evolved over time by moving a myriad of services onto the different blockchain environments, completely decentralizing them and cutting out the middleman from each and every one of them. In the centralized model of finance that is pretty conventional, you have to have a middleman or a mediator for the sake of initiating even the most base transaction or any other request that is tied with money.
It is nothing but a marketing tactic employed by those big corporations by having a middleman between you and them for the sake of feeding you indirect information about the services that they are offering and helping themselves by arranging a middleman to automate the whole setting for them.
As a cherry on top, those middlemen have their salaries or what everyone said they’re enjoying trickled down from the transaction fees or other such arrangement fees that you offer to the corporation. So it is kind of a big chunk of cake that you are giving these corporations for free in terms of transaction fees and whatnot. Decentralized finance aims to stop all of these tactics by completely bypassing the need for a mediator.
Liquidity pools are the direct offerings of decentralized finance, and they have helped the whole decentralized finance ecosystem by allowing the fundamental technology to have decentralized trading available, and these pools work as a growth catalyst for the decentralized community.
Before you get to learn about decentralized finance or these mining pools, it is important to have some kind of background information on the term liquidity, what is it what is the chronological hierarchy, and what should you know about it before you move on to these big topics;
What is Liquidity?
To better understand the concept of liquidity and how it applies to an asset, it is best to consider an example through which you would be able to pinpoint exactly what liquidity is, how it works what can you do about it. Suppose you have this antique art piece with you that offers incredible intrinsic value because it was painted by this famous painter in that specific era, and it is just over the top when it comes to the overall worth of this piece.
Now the downside is that the art market is not at its best right now, investors have lost their touch with antiques, and for that reason, you are not able to sell that antique painting. It has got amazing value, but people only want to snatch it from your hands for half its price or even lower, so what can you do that?
This is a financial asset that is not at all liquid, which means that it is highly illiquid. The same might be the case with a dedicated cryptocurrency out there; it might have an incredible intrinsic value and could propose a significant or sharp increase in its price factor, but at the moment, it is being sold for pennies on dollars which is why it has become highly illiquid, no one wants it, and if you have got a bunch of them then you are already in trouble.
Suppose you want to sell that particular cryptocurrency and just want to get rid of it as soon as possible because you are in dire need of cash, but because of the volatility of the crypto market, you just can’t do that. Even if someone is willing to buy that specific crypto from you, they are only willing to pay you half of its price or even low.
Therefore, having a liquid asset and, more importantly, a liquid market is a must if you want to make sure that you are able to sell off your business or whatever assets that you have at hand at any given time within a moment’s notice then it is an incredibly important element to have.
As water is important for living beings to sustain their lives and to make sure that their bodily functions are working at their best then, the same is true for liquidity, it is the lifeline of any potential market entity out there, and you just won’t be able to have a successful interaction with any potential market without it being highly liquid.
Liquidity not only determines but also affects the price of the assets, the overall price gaps which are going to change over time and all-time highs and all-time lows, and also it has a corresponding effect on the price reduction, volatility along with the cost of investing into that particular asset.
How Do You Create Market Liquidity for an Asset?
If you were thinking that, like volatility, liquidity is a measure of how the market is performing at the moment, and it comes and goes on its own terms, then you need to think again, liquidity can’t be created naturally, as is true with volatility and other associated factors of various financial assets. You need to create liquidity on your own, either for the market you are engaging with or the crypto asset or any other financial asset that you are dealing with.
The centralized crypto exchanges out there, such as Binance or Coinbase, present their users with multiple lists of buy and sell orders that are known as the order books. These orders usually come from the participants of the market who agree to either buy or sell an asset over a certain price. This means that they have already agreed upon a particular price for a dedicated asset, and they want to either buy assets at that predetermined price or they want to sell these.
At any given instance, if the market is meeting its particular conditions, these orders are going to get fulfilled on their own, but until that happens, these open orders will remain pending, which helps create liquidity.
Now you might be thinking that any simpleton can just ring up any centralized crypto exchange out there and create their own open orders, but that is not the case, So what you want to do here is that you need to have a proper assortment of financial credibility to be able to open orders with a particular centralized crypto exchange, you need to fulfil some of their requirements in order to become that top tier user with that particular crypto exchange.
As far as the decentralized crypto exchanges are concerned, liquidity and their creation are pretty different. There are potentially no order books on these decentralized exchanges nor in their systems; instead, all the assets are going to be traded with the help of a liquidity pool that is operated using the decentralized technology, it is known as automated market makers.
What it does is that you have an automated system in which you punch in all the details once and for all, and it takes care of the rest. You don’t need to worry about anything or have to click stop or navigate in between menus to be able to pinpoint the exact element that you are looking for. A simple search would help you to do that, but in reality, these are not as potent as the centralized crypto exchanges because of the whole centralized vibe going on.
What is a Liquidity Pool?
A liquidity pool is like a medium that consists of pretty much every major cryptocurrency that has ever been listed or traded in the past and is recently acquired by the crypto market itself; it has tokens that are locked in a decentralized manner and are using smart contracts for the sake of developing liquidity for all the market participants. You might be thinking about how all of it is possible because of an elegant concept portrayed by the brilliance of decentralization and blockchain technology.
All the users who want to engage with decentralized finance are welcome to join in a dedicated liquidity pool by staking their crypto tokens for a definitive period of time, but when they are doing just that, they actually can’t take away their crypto tokens for the period of time they earlier decided to lock these in. In the most basic sense, a liquidity pool is nothing but a decentralized market having the critical working model of multiple decentralized exchanges banded together and working at their extreme.
In the past, multiple decentralized exchanges used to suffer because of literally having no trading activity whatsoever. Most of the people out there who want to engage with cryptocurrencies are naturally drawn toward the idea of centralized exchanges, developing their own user accounts, and then having to trade their money into those particular assets.
Therefore decentralized exchanges used to have zero to no user activity, the trading volume was extremely low, liquidity was next to nothing, and therefore it was necessary to make some changes and make decentralization once again the top of the financial game.
The traditional model for order booking that centralized exchanges used to present didn’t actually work with the decentralized exchanges at all. There were possible drawbacks and limitations that required a centralized intermediary and a middleman to tackle things that are strictly against the prospects of decentralization and blockchain technology.
The automated market makers, with their proposed technology and the liquidity pools, have since changed the situation for good. These decentralized auto market makers have brought the possibility for decentralized exchanges to have liquidity with the help of these liquidity pools.
Multiple incentives and rewards are proposed to those who want to stake their crypto tokens within these liquidity pools for the sake of having enough liquidity; these people are presented with these rewards either in the form of the crypto that they just logged into that definitive mining pool or through some other fashion of incentive.
This automated market-making solution has essentially changed the decentralized exchanges and how these work for good. It has since fixed the problem of having little to no liquidity and has acted as a pivoting point for the growth of the whole decentralized finance ecosystem.
Working Mechanism of Liquidity Pools
If you want to truly understand how a liquidity pool works, then it is important to know a thing or two about how these liquidity pools actually get their hands on the liquidity in the first place. This is done to determine the overall price of the assets, and therefore, it is important to understand from where these liquidity pools bring in the liquidity.
The automated market makers out there are in charge of creating the liquidity pool or dedicated potential decentralized market to accommodate certain trading pairs of different digital assets. The liquidity providers that are primarily in this setting propose various settings for the liquidity pool; they are actually in charge of setting the initial price and proposing equal supply for both the assets involved.
When these liquidity pools begin to fill up with assets that the market participants have made available in the smart contracts, the liquidity profile for that particular liquidity pool begins to rise up. These users are known as the liquidity providers, and anyone can become a liquidity provider as soon as they are bringing in tokens into the pool itself.
These liquidity providers bring your tokens into the pool with the help of staking. This is a method that allows these users to have their cryptocurrencies or tokens added into a dedicated mining pool for a certain period of time, thus locking away their assets which means that they can’t use or withdraw these tokens even if they want to because of extreme regulation that this particular segment of the market imposes.
Your assets are going to be locked into a dedicated protocol for a particular period of time; these assets then continue to circulate within the liquidity pool aligning for decentralized trading, whereas the original owners continue to earn passive income for the contributions they have made by depositing their crypto tokens.
These liquidity providers do earn special tokens for the sake of bringing a supply of liquidity to the pool. These tokens are known as the liquidity provider tokens and are provided or given to the people in the context of how much contribution they have made to the mining pool.
Whenever the liquidity provider asks for the withdrawal of their tokens, which they earlier committed, the mining pool of the liquidity provider token which was given to them earlier is burnt because it has fulfilled its purpose and is no longer authentic.
Advantages of Liquidity Pools
The first and foremost benefit of using liquidity pools is that you don’t require any reliance or dependence on the traditional market makers or having the need to place an intermediary to automate transactions on your behalf.
It is much more profitable than holding your crypto tokens because this way, you get to see profit booming in from the very start because your assets are going to generate passive income, which provides you with passive returns as for waiting with the crypto you might not be able to see a profit even after holding your assets for a particular period of time.
The rewards that are awarded to the users for the sake of providing liquidity to the mining pool are far better than waiting out for the market to turn the tide which is optimistic, to say the least.
These mining pools make sure that you have a regular stream of income, especially in the events of the markets slowing down. Because people would continue to interact with these mining or liquidity pools and you would be well covered for your contribution to the whole act.