Liquidity Pools — The Central Bank of the DeFi World (Sort Of).

First What is a Liquidity Pool?

Ignore Beyoncé and focus on what surrounds her — the pool of money (pun intended). Seriously, a Liquidity Pool is literally a virtual pool of money. Like a safe full of electronic money — that’s the definition (see what I did there? huh? huh? DeFinition).

No more puns, I promise, Moving on.

You’ll probably find other definitions like a Liquidity pool is “crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (DEX)”.

Too wordy, too complex. A liquidity pool is just digital money in digital safe.

Why Liquidity Pools?

I called them the ‘Central Banks of Crypto’ and that’s what they do. They store money and trade with it. While they don’t make new coins they’re banks in every other way. (Here’s how the coins are made).

Their major function is decentralized trading.

If you don’t already know, trading require a buyer and a seller.

That’s why I never really liked the term dump. When you ‘dump’ coins you still sell them to someone, as opposed to what dumping sounds like. Confused a younger me.

The buyer - seller set up causes a huge ass problem in DeFi.

What happens when there are no buyers ?.

Exchanges like Binance solve that problem by creating a becoming a central entity that’s always ready to buy coins, a bit ironic but it gets the job done.

The problem is that it ruins crypto, I recently got restrictions on my Binance account for not completing KYC. That’s not a huge problem for me but imagine the dude who made 5 billion USD from an $8K investment on Shiba Inu wants to sell while remaining anonymous.

(Temporarily ignoring Elon Musk and his ballooning Wealth.)

Nobody, I mean nobody can take all the SHIB off his hands at the current price.

Who the fuck’s going to pay 5 Billion USD for Doge 🐕 Coins.

In a world without liquidity pools his newly amassed wealth would be worth nothing.

Liquidity pools allow trading without the need for a third or even a second party. Party of One — Party of Fun.

In summary, Liquidity Pools solve the no buyer issue in a decentralized way.

How Liquidity Pools Work

Like I said they’re a huge pool of money, the intriguing part is how they play bank while remaining decentralized.

When a liquidity pool is created, it must be funded, (in it’s simplest form with two tokens).

Who ever supplies the first set of tokens determines their original price in the pool.

If I supply 30 BNB and 10,000 Me Tokens it means 10,000 Me = 30 BNB.

Liquidity Providers are incentivized to supply the tokens in equal value to their current prices. If the tokens are not supplied in equal value, then there’s a risk of Liquidity Providers losing their money due to price divergence.

Once the first set of tokens are supplied, trades can happen.

When someone buys, the algorithm of the Liquidity Pool adjusts the prices based on what tokens were added and which one was removed.

Take an BNB/ETH pool for example.

Let’s say I have some BNB but I’d rather have ETH, if I take out some ETH from the pool, the amount of ETH reduces and I add more BNB.

Laws of Supply and Demand take over and the price of ETH in that pool rises. The reverse happens when I add ETH instead of BNB.

This way trades can happen without a second party or need for centralization.

DeFi 1– 0 Human Interaction.

What’s in it for Liquidity Providers.

Like I said Liquidity Pools are decentralized, so their funding must also be decentralized. We do this by anonymous people fund the pool.

Why would anyone leave money on the table (or in the pool).

Simple — They get paid.

Liquidity Providers get special tokens called LP tokens based on how much liquidity they add.

The LP tokens are like NFTs, they’re certificates. As long as they hold someone holds LP tokens, they get a percentage of the transaction fees based on how many LP tokens they hold.

In the event that LP holders want their money back, they burn the LP tokens, get their money and the transaction fees.

That’s all on Liquidity Pools.

Glossary

Smart Contract: A Smartcontract is code that runs when certain conditions are met. They’re the basis of dApps

I’ll probably do a piece on them soon.

Claimer: I proudly announce that the memes used here are self made.

You can copy them without fear.