There’s no denying the fact that the concept of decentralized finance (DeFi) has garnered a lot of traction amongst crypto enthusiasts/ investors across the globe in recent years. In its most basic sense, the word DeFi can be thought of as an umbrella term that describes any financial product, or service that has been built using blockchain technology.
To put things into perspective, the total volume locked (TVL) — i.e. the amount of capital — within the DeFi market currently stands at $107B, with conservatives estimates suggesting that this metric will touch a whopping $507.92 Billion by 2028 at a steady compound annual growth rate (CAGR) of 43.8%.
That said, it is worth mentioning that the success of the global DeFi ecosystem hinges on a little concept known as ‘liquidity pools’. To put it simply, without them, popular activities such as decentralized lending, borrowing, or token-swapping would not be possible. To elaborate, liquidity pools are an innovation that is exclusive to the cryptoverse with there being no direct equivalent to it within the realm of traditional finance.
Not only do liquidity pools help facilitate the core activities associated with any DeFi protocol, they also function as a means through which investors — with a high appetite for risk — can accrue handsome rewards within the shortest time period possible.
What are liquidity pools (LP)? What are some different kinds of LPs?
A liquidity pool can be envisioned as being a collection of funds locked within a smart contract, i.e. a self-executing contract where the terms and conditions of the deal have been pre-defined and written into lines of code. These funds can be used for a variety of purposes including decentralized trading, lending, borrowing, yield farming, development of synthetic assets, etc.
There are a number of DeFi platforms in the market today making use of varying styles of liquidity pools to great effect. Centrifuge is one such offering, whose associated Tinlake ecosystem serves as a lending protocol as well as marketplace for real-world asset pools. Any investments made within the platform allow clients to reap incentives in the form of ‘CFG’ — Centrifuge’s native token offering.
To elaborate, Tinlake allows originators and owners of assets in the real world — ranging from invoices, residential real-estate loans, etc — to seamlessly devise a pool of their assets and offer them to DeFi investors all across the globe. These assets can be used to generate stable yields while providing liquidity to issuers and borrowers operating within the ecosystem.
Similarly, Balancer is another Ethereum-based liquidity pool designed to serve as a non-custodial portfolio manager and price sensor. When making use of the protocol, users cannot only harness the power of customizable pools but also earn trading fees by simply subtracting or adding liquidity to the ecosystem. As a result of employing such a modular pooling protocol, Balancer is able to provide support to multiple pooling options, including private, smart, or shared pools. Furthermore, liquidity pool owners on Balancer have the right to offer capital as well as alter the parameters of a private pool as they see fit.
Why is liquidity key in DeFi? How is liquidity keeping DeFi going?
Straight off the bat, it should be noted that whenever a protocol’s liquidity slips below a certain level, the issue of ‘high slippage’ arises, which is the gap between the expected price of a token and the rate at which it is actually traded. In addition to this slippage problem, low liquidity can also result in investors being stuck with tokens they cannot sell (which is what happens in the case of ‘rug pulls’, as well).
As to how liquidity pools have been keeping the burgeoning DeFi ecosystem thriving, they serve as a means for investors and liquidity providers to earn token-based rewards. In fact, such a reward-based structure has given rise to various lucrative investment strategies. Yield Farming, for example, is one such option where investors can move assets across different protocols in order to reap high yields before they eventually dry up.
Also, it is worth mentioning that most liquidity pools provide their users with LP tokens — i.e. receipts of sorts for network participation — which can later be swapped for rewards, either directly from the pool itself or staked on other protocols for the generation of additional yields.
Looking ahead
As the world continues to gravitate towards the use of finance options rooted in the ethos of decentralization, it will be interesting to see how more and more people continue to move towards liquidity-based platforms, especially since they stand to deliver yields that are are on a completely different level when compared with traditional options such as fixed deposits, savings bank accounts, etc.
Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice
