How to Use Liquidity Builders on DEX Platform?
Liquidity pools provide liquidity to decentralized exchanges to swap coins, as well as for borrowing and lending activities.
Liquidity pools are one of the most revolutionary innovations in the decentralized finance (DeFi) ecosystem that facilitates trading on decentralized exchanges (DEXs). Liquidity pools are basically pools of coins locked within a smart contract. They provide liquidity to decentralized exchanges to swap coins, as well as for borrowing and lending activities.
On centralized cryptocurrency exchanges, market makers facilitate trading by making it easier for traders to buy and sell a particular coin, thereby providing liquidity. However, in the case of decentralized exchanges, excessive dependence on external market makers may result in transactions becoming relatively slow and expensive.
This is where liquidity pools come into picture and address the issue by functioning as an automated market maker. Almost all decentralized exchanges use liquidity pools to ensure and maintain a liquid market for crypto assets.
The first-ever protocol that introduced liquidity pools was Switzerland-based Bancor, but they became widely popularized by Uniswap. Some protocols like Uniswap, SushiSwap, Balancer, and Curve are on Ethereum blockchain and exchanges utilize ERC-20 tokens, while others like BakerySwap, PancakeSwap, and BurgerSwap are on Binance Smart Chain (BSC) and exchanges utilize BEP-20 tokens.
Users called liquidity providers add equivalent amount of two tokens (pairs) in a specific pool for creating a market. In return, for providing their funds, they earn trading fees from trades that happens in their specific pool, proportionate with their share in the total liquidity thus able to generate passive income on the crypto assets they have sent to the pool.
Mechanism of Liquidity Pools
The liquidity pool usually consists of a pair of tokens. For a specific pair of tokens, pools generate different markets. So users called liquidity providers add equivalent amount of two tokens (pairs) in a specific pool for creating a market.
The initial price for each asset is set by the pool creator. In case pool’s pricing is not in line with the global crypto market, the liquidity provider are subject to risks of losing funds
As more and more liquidity providers add their funds to the pool, it becomes important to keep tokens in line with market prices. As the liquidity pool enables token swaps, the asset price will adjust based on a pricing algorithm. Every liquidity pool use its own algorithm/methodology to calculate the token price.
The algorithm guarantees that the pool always has sufficient liquidity regardless of magnitude of trade. These are often referred to as Automated Market Makers (AMMs).
The most popular liquidity pools consist of token pairs involving stable coins and ETH because people need to convert from crypto to fiat and vice versa, and stable coins are a preferred coin. Actually the token ratio manages the pool’s price. In case of USDC/ETH pool, if somebody buys USDC from the pool that increases the volume of ETH, which raises the price of USDC and lowers the price of ETH
The total change in price will depend upon on how much the individual/trader bought and by how much pool was changed. Larger pools exhibit fewer variations as it takes massive trades and purchases that are needed for changes to occur
In return, for providing their funds, they earn trading fees from trades that happens in their specific pool, proportionate with their share in the total liquidity thus are able to generate passive income on the crypto assets they have sent to the pool. Sometimes, these transaction fees are reinvested into the liquidity pool to boost the value of tokens and growth of the pool
Liquidity Provider Token (LPT)
When liquidity providers deposit their funds in a pool, they get a liquidity provider token (LPT). These tokens are used to determine the amount of funds the provider has contributed in a pool and the share of transaction fees they will receive for providing liquidity. These tokens also enable them to have control over their assets while they are in the pool.
As LPTs generally have the same properties as other tokens of the blockchain, they can be staked, traded or transferred to other protocols of the same blockchain.
For example, a BNB-BUSD LPT can be staked on PancakeSwap to earn the trading platform’s protocol token, CAKE.
Liquidity pools provide a user-friendly platform for both decentralized exchanges and users. For exchanges, the presence of liquidity pools enables the decentralized nature of DEXs to function smoothly and by enabling trades to happen asynchronously, it is driving the growth of decentralized finance (DeFi).
For users, various DeFi projects continue to provide them with more diversified liquidity pool models resulting in participants, with different risk preferences, getting more and more choices. Here it is important to note that the blockchain networks on which liquidity pools are hosted provide an additional layer of security, enabling both traders and LPs to transact securely.
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