DeFi Liquidity Mining Pool Explained

By DigiFinex | DigiFinex | 10 Feb 2021


In decentralized markets, DeFi liquidity pools have arisen as a creative and automated way to address liquidity challenges. They substitute the conventional model of order books used by centralized crypto exchanges, taken straight from the developed stock markets.

What is a DeFi Liquidity Mining Pool?

A DeFi liquidity pool is a smart contract that locks tokens on a decentralized exchange to guarantee certain tokens' liquidity. Users that have smart contract tokens are referred to as liquidity providers.

The exchange functions as a market in this model, where buyers and sellers come together and negotiate on commodity values dependent on relative supply and demand. This model, though, relies on there being enough buyers and sellers to generate liquidity. Consequently, the market makers' role exists to ensure that there is still someone to satisfy the demand by contributing liquidity, essentially holding prices equal.

For a decentralized exchange, the basic model has proven to be unsuccessful. The gas costs and slow block time of Ethereum make it unattractive for market makers, resulting in low liquidity for the attempt of DEXs to reproduce the concept of the order book. In decentralized finance, liquidity pools have become the go-to option of choice, providing constant, automated liquidity for decentralized trading platforms.

How do They Work?

The simplest variant of a DeFi liquidity pool holds two tokens in a smart contract to form a trading pair.

As an example, let's use Ether (ETH) and USD Coin (USDC), and to make it fast, the ETH price can be equivalent to 1,000 USDC. Liquidity suppliers apply an equal amount of ETH and USDC to the collection, meaning that will have to be balanced with 1,000 USDC by those depositing 1 ETH.

The liquidity in the pool ensures that they can do so depending on the funds invested anytime someone tries to exchange ETH for USDC, instead of waiting for a counterparty to fit their trade.

Liquidity providers are incentivized for their contributions. They earn a new token representing their interest, called a pool token when they make a deposit. The pool token in this example would be USDCETH.

The share of trading costs charged by users who exchange tokens using the pool is automatically allocated to all liquidity suppliers proportionate to their stake size. So if the USDC-ETH pool's trading fees are 0.3 percent and 10 percent of the pool has been contributed by a liquidity supplier, they are entitled to 10 percent of 0.3 percent of all trades' net value. Thus, they burn their pool tokens and will remove their stake anytime a customer tries to withdraw their stake in the liquidity pool.

The Dark Side

Algorithm. The algorithm that decides an asset's price could fail, slippage due to large orders, failure of a smart contract, and more. The asset price in a liquidity pool is set by a pricing algorithm that changes continuously based on the pool's trading operation. Arbitrage traders who take advantage of pricing fluctuations across platforms will switch and benefit from the volatility if the price of a commodity differs from the global market price.

Liquidity providers can suffer a loss in the value of their deposits, known as an impermanent loss, in the case of market fluctuations. However, the deficit becomes permanent if a supplier withdraws their deposit. It is possible to cover any deficits with transaction fee rewards, depending on the scale of the fluctuation and the amount of time the liquidity supplier has staked its deposit.

Smaller pools will suffer from slippage because of the pricing algorithm if someone unexpectedly tries to position a significant transaction. There have been cases, such as the bZx hack in 2020, where users manipulated smaller liquidity pools as part of a larger market manipulation assault.

If the underlying code is not audited or completely protected, DeFi users face other threats, such as smart contract failure. Before depositing any money, make sure to consider all the risks.

The Bright Side

The most apparent advantage of liquidity pools is that traders wishing to use decentralized markets are ensured a near-continuous stream of liquidity. By being a liquidity supplier and collecting trading commissions, they also provide the ability to benefit from cryptocurrency holdings.

Also, several initiatives and protocols would give liquidity providers additional benefits to ensure that their token pools stay high, reduce the risk of slippage and create a better trading experience. Thus, in exchange for being a liquidity provider, there is a potential to produce more profits from yield farming reward tokens.

Like in Uniswap, Balancer, and Yearn, finance, award liquidity providers in their platform tokens, in the summer of 2020, as SushiSwap emerged, it used this model to initiate a so-called "vampire attack" on Uniswap.

What Else to Take Note of?

In general, you would have to set up an account on the platform of choice and an Ethereum wallet. After that, you can then deposit your tokens in the associated liquidity pool. Additionally, you will have to check for a particular pair on platforms such as Uniswap to provide liquidity to and then link your wallet.

For related articles, read DigiFinex Academy.


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