The purpose of cryptocurrency liquidity pool is the same as that of market makers, but they eliminate the centralized hierarchy of traditional finance. Decentralized Exchange (DEX) does not rely on a third party like Citadel, but allows anyone to "pool" their cryptocurrencies onto a platform to facilitate trading. Why do liquidity pools change the financial industry? After reading this article, you may get the answer you want.

How does liquidity pools change the financial industry?

Liquidity pools provide a novel solution for providing secure encrypted liquidity in DeFi (decentralized finance). Independent smart contracts, open source code and information easily accessible to ordinary investors will weaken the power and influence of central market makers. Liquidity pools provide a simple and untrustworthy way for crypto investors to trade or deposit funds to obtain passive returns.

Although the total value locked in the liquidity pool (TVL) has increased since Uniswap was launched in 2018, it is still in its early stage of development. Exchanges such as Yen An still provide greater liquidity for cryptocurrency traders.

However, if the DeFi industry grows, the liquidity pool will provide a new market making model. It is not just DeFi tokens that can be used for trading. In the future, more dex may provide securities tokens representing synthetic stocks, ETFs (exchange traded funds) and precious metals. The more popular the liquidity pool and dex are, the less influential the centralized market will be.

Security considerations for liquidity pools

Although liquidity pools are exciting, there are risks in depositing funds into these smart contracts. People need to review common LP risks to manage their crypto portfolios. Among them, an important problem of becoming LP is a phenomenon called transient loss. Because the liquidity pool is constantly adjusted to maintain the same proportion of tokens. Therefore, as the price of digital assets changes, the balance of your cryptocurrency in the liquidity pool will also change. The impermanent loss refers to the "loss" that is more substantial than simply holding cryptocurrency.

For example, you can save 1 ETH and 2000 USDTs into the Uniswap ETH/USDT pool. Uniswap's liquidity pool requires LP to deposit tokens at a ratio of 50/50. Therefore, at this time, 1 ETH equals 2000 USD. Or, when you provide liquidity, there are 50 ETHs and 100000 USDTs in this pool. This means that you have a 2% share in the liquidity pool, and the constant "k" value is $200000.

If the ETH price soars to 4000 USDT, the total ETH balance in the liquidity pool will drop to 25 ETH as the arbitrage traders balance the liquidity pool. If you withdraw your token now, you will get half of your original deposit. Although your 0.5 ETH is still 2000 USD, if you only hold the first ETH, its value will double.

Note: This example does not include all token rewards you have received during this period. In addition, this example assumes that no one else increases your pool liquidity.

In addition to the risk of volatile losses, the new LP needs to remember that DeFi is an unregulated space. There is no insurance protection on dex, so if there are hackers or bugs in the smart contract code, you may lose all your funds. At present, many experts suggest sticking to the highest profile dex and giving priority to dApps (decentralized applications) with high TVL and long-term tracking records. Some of the most prominent indicators include:

Uniswap

Curve finance

Pancake exchange

Balancer

ending

The mobility pool is a great leap forward for DeFi ecosystem. If liquidity pools become more prominent, they can balance the impact of centralized market makers on trading platforms. Although smart contract technology is still in its infancy, it seems that the liquidity pool is expected to become a democratic tool for global traders.