Liquidity pools are a vital component of decentralized finance (DeFi) platforms. Liquidity pools are typically created by users who invest assets (usually two tokens of equal value) in decentralized exchanges for a share of the pool's tokens or LP tokens.
LP tokens represent a claim on the assets in the pool.
This type of DEXs in DeFi, also known as AMM - automated market maker.
Automated because the user makes his trades trow a smart contract deployed on the blockchain, it provides unlimited access at any time.
Market Maker because all users trades make market 🙂 Price = Token A / token B
Here is the video explainer of how AMM works >
After the liquidity provider, here comes, the trader exchanging some amount of token A for token B. He can directly interact with pool smart contracts on DEX to trade assets quickly and easily without waiting for a buyer or seller to be found. All these operations execute in a decentralized network and work 24/7 without KYC.
The presence of liquidity pools in DeFi protocols helps to increase the platform's efficiency. Additionally, by decentralizing the market-making function, DeFi protocols aim to eliminate the need for centralized exchanges, which can be subject to censorship, hacking, or other security risks.
Here is a real example of a liquidity pool from PancakeSwap on BSC. Pool Cake / WBNB:
In this pool, we have two assets, CAKE and BNB
Total liquidity 221.64m, half 110,82m in CAKE and 110,82 in BNB
Liquidity providers earn 0.63% APR from trades
Now we have a simple concept of liquidity pools where we invest two tokens into the pool, equally 50% of BNB value and 50% of CAKE value. As a liquidity provider, we will earn 0.63% APR on this pair from fees on trader's transactions. But in a competitive market with many DeFi chains and DEXs, more is needed to attract liquidity.
So the DEX will start the incentivization program by distributing its own Governance token. PancakeSwap will offer you an extra reward when you participate in providing liquidity to bite the competitors and attract more liquidity.
Here you can check farming opportunities on PancakeSwap. You can receive up to 37% APR by staking your LP tokens from CAKE/BNB pool into the Farming smart contract.
DEXs are starting liquidity mining to incentivize users to provide liquidity to their platforms. By offering extra rewards to users who provide liquidity, protocols can attract capital and build up their liquidity pools, making their platforms more attractive to users.
Users who provide liquidity to a DeFi protocol can earn a portion of the fees generated by the protocol. The same goes for protocols. They also make fees on the trades.
So the more liquidity is attracted, the more deals will be made, so the volumes passing through this pool will grow. As a result, the protocol and the liquidity provider will earn more.
You can learn more about farming and liquidity mining in our next article →
It is important to carefully evaluate the risks and potential rewards of any Farming before committing capital. The DeFi market is highly volatile and can be subject to rapid changes in market conditions. Additionally, there is no guarantee that a DeFi platform will be successful, and it is possible to lose all or part of your investment.
To learn more about how to choose a secure yield farming platform, check this article>.