Updated: Mar 10, 2021
It's an interesting time to be alive. With DeFi (decentralized finance) and cryptocurrency, there are more ways than ever to make passive income. Liquidity pools are yet another great opportunity to make money. Though it's been around for years in other forms, definitely not like this. This post will introduce you to the nitty gritty of liquidity pools, followed by an engaging video by Finematics to explain the ins and outs even further.
What are Liquidity Pools?
Liquidity pools, in essence, are pools of tokens that are locked in a smart contract. Their purpose is to facilitate trading by creating more liquidity. Liquidity pools are used by many exchanges. However, liquidity pools are often more used by decentralized exchanges (DEX).
During this year's surging popularity of DeFi, one of the first platforms that introduced liquidity pools was Bancor. Bancor is a blockchain protocol that allows customers to convert a multitude of cryptocurrency tokens instantly into other tokens. This is often more popular than exchanging them on crypto exchanges like Binance and Coinbase. The Bancor protocol assists smart tokens in price discovery and continuous liquidity for cryptocurrencies. It does this by utilizing constant ratios of reserve tokens held through smart contracts.
Liquidity pools got ultra popular with the advent of Uniswap, a fully decentralized platform which allows users to swap into Ethereum (ETH) or any Erc20 token (like Compound). Users can also contribute to liquidity pools to earn a percentage of the trading fees. How much? When a user contributes Erc20 tokens or ETH to a liquidity pool, they will receive a proportional percentage of the 0.3% swap fees. For instance, if you contribute 5% of the total Ethereum in the liquidity pool, you will receive 5% of the 0.3% fee. All this is done through decentralized smart contracts, which ensures users are always in control of their money.
Then Curve, another decentralized exchange liquidity pool, implemented a different algorithm to offer lower fees and lower slippage when exchanging tokens that should be the same price like stablecoins. Lastly, Balancer took these ideas even further. Balancer realized it's not necessary to only ever have 2 assets in a liquidity pool, and in fact allows for as many as 8 tokens in one pool.
Watch the Video on Liquidity Pools
Below is an excellent video on liquidity pools by Finematics. It helped me and my fellow crypto enthusiasts better understand this engaging, money-making product.
Like investing in traditional finance, DeFi also poses risks, albeit more unique. With liquidity pools there are many of the usual potential risks. The most glaring of these include smart contract bugs and systemic risks. Lastly, if you are not careful with your admin keys, you can lose your crypto forever.