A guide to Liquidity Pooling

A guide to Liquidity Pooling
A driving force behind the success of the Decentralized Finance (DeFi) sector is liquidity pooling. To date the DeFi sector continues to disrupt the financial sector by offering decentralized financing. Daily trading volume on DeFi markets is well over $15 billion and boasts with a market cap of more than $60 billion. However, none of this would have been possible if it was not for liquidity pooling. So, what is liquidity pooling and why is it important?

What is Liquidity Pooling?

As you may know, you cannot sell something you don’t have. If an exchange doesn’t have coins aka liquidity to sell, it cannot function properly. This is where liquidity pools come in. Liquidity pools consist of user funds that are locked away in the pool by means of a smart contract. These tokens ensure token pair liquidity on a Decentralized Exchange (DEX). These liquidity providers, which can be anyone or any project, benefit by earning returns from the trading fees. The amount of earnings depend on which pool the liquidity provider falls under.

Trades on a DEX are regulated by Automatic Market Makers (AMM). AMM replaces order books and means that you can effectively trade with other traders as oppose to trading the order book on an exchange.

Liquidity pooling is great way for traders to buy and sell cryptocurrencies in an innovative, automated and permissionless way.

Pros and cons of becoming a liquidity provider

Becoming a liquidity provider is a great way to earn passive income on your liquidity and at the same time, help others to trade on a DEX. Here are the pros and cons of becoming a liquidity provider:

Pros

  • Since you are providing liquidity to a DEX, you will be handsomely rewarded. If your hodling a coin for the long term, this is a great way to earn more from your investment.
  • In order for a DEX to be fully decentralized, developers are turning the platforms into community-owned projects. Some DEXes reward liquidity providers with governance tokens that gives them voting rights on important issues that affect the exchanges. These governance tokens are a second form of reward for liquidity providers. With your vote, you can change protocol and even add more liquidity pools.
  • A good example of such a governance token is Compound (COMP) that is rewarded to liquidity providers on the Compound lending platform. If you earned COMP tokens, you can send them to your AltCoinTrader account and sell them for a range of other cryptocurrencies or simply cash out.

Cons:

  • Your funds are deposited into a pool that acts as a temporary custodian, by means of a smart contract. Should the smart contract get a bug or hacked or exploited, the funds may be lost.
  • Stay clear of platforms with an admin key or feature privileged access. This could leave liquidity providers vulnerable to exit scams.
  • There is also a risk of impermanent loss of funds.
In conclusion, thanks to the help of liquidity providers, the DeFi space has grown immensely. It will continue to grow as long as investors remain interested.