The digital currency and encrypted assets market or the crypto market is developing rapidly, which has made the technologies and concepts surrounding it increase cyclically, especially the field of decentralized finance, which has also resulted in the emergence of many new technologies, including liquidity pools for decentralized trading platforms.
What are liquidity pools?
A liquidity pool is a reserve of cryptocurrencies deposited into a decentralized exchange such as Uniswap, by a group of individuals, so that others can buy these cryptocurrencies.
The difference between a traditional centralized and decentralized cryptocurrency trading platform
On a decentralized finance platform like Uniswap everything works automatically thanks to “smart contracts”. So people have to agree to provide these platforms with cryptocurrency to keep their liquidity high. The principle, which has been built on Uniswap and repeated in many other decentralized platforms, is that of liquidity pools.
In fact, a “pool” is a pair of two cryptocurrencies that can be exchanged for one another and the user agrees to deposit without touching what he deposited during a certain period. The pair forming the pool must have an equivalent value (50/50) at the time the pool is created.
The person who agrees to provide this liquidity is called LP (Liquidity Provider). The LP could decide to reserve BNB and Shiba in Uniswap, each pair representing the same value. Others will then be able to buy some BNB or Shiba. In a way, these liquidity providers offer these cryptocurrencies to Uniswap, and in return, they get a commission. Thus, every time a transaction takes place on Uniswap and includes one of the respective liquidities, the LP shareholder collects 0.3% of the transaction.
On the other hand, liquidity pools are subject to a specific risk called non-permanent loss which means that in certain situations, the LP will earn less than they would have earned if they had not created that pool.
The importance of liquidity pools
Central platforms such as “Binance” or “Coinbase” rely on a different trading system called the order book. In this model, buyers and sellers come together to place their own orders. For exchanges to take place, the price set by the buyer must be the same as the price set by the seller. To do this, market makers come into play.
Market makers are individuals, professionals or companies, who ensure the completion of each order by providing their own liquidity, hoping to take advantage of the spread (the difference between the buy and sell price) on a particular market.
In fact, the activity of a market maker requires the permanent placement or withdrawal of buying or selling orders. In other words, the lack of transactions per second results in poor performance of decentralized order books.This is why a new solution is necessary, to ensure decentralized exchanges.
Using liquidity pools and automated market makers is a possible solution to this problem.
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