In the past few years, several centralized crypto exchanges have created the opportunity for users to have access to the purchasing of cryptocurrencies but these as good as they may sound have also caused a lot of harm to lots of newbies who may not understand the dynamics of how crypto exchanges work.
This has caused a lot of users to lose their funds as a result of signing up to most of these exchanges that really can not account for the services they render to their customers.
Some of the challenges associated with these exchanges include but are not limited to the following:
- Poor security architecture for the exchange
- Poor customer service
- Poor experience of the management team
- Poor liquidity to service the exchange.
These are some of the key inputs to determine a viable and reputable exchange for trading purposes. However, this article is focused on the issue of liquidity pools and how they help the exchange to thrive effectively.
What is liquidity?
A simple definition of liquidity is the ease or flexibility in which an asset or security can be converted into cash. In the traditional finance market, this is totally necessary for all financial institutions as it can be used to execute all sorts of transactions and financial instruments.
The same is applicable to the cryptocurrency space where coins and tokens are referred to as assets and can also be supplied as liquidity for seamless exchange of funds.
What are liquidity pools?
In a simple way, liquidity pools are basically funds thrown together or aggregated in a big digital pile for ease of transactions. In other words, These pools are a collection of tokens or digital assets stored in a smart contract.
In traditional finance, liquidity is provided by buyers and sellers of an asset and this can be replicated in centralized exchanges such that such exchanges would be expected to have a large chunk of funds stored as reserves which would be used for executing trades on the exchange.
However, there is another type of liquidity that is provided in a decentralized manner hence the liquidity pool for decentralized exchanges.
The core technology behind the current DeFi ecosystem is liquidity pools. They form a fundamental piece of yield farming, lend and borrow protocols, automated market maker (AMM), engineered resources, on-chain protection, blockchain gaming, and so on.
In all trades, wealth managers and investors can encounter a difference between the expected price and the executed price for the trades. This is very common in both traditional markets which include stocks, bonds, and also crypto markets. Therefore, the liquidity pool strategically aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.
What are the benefits of the liquidity pool on DEX?
A decentralized exchange without liquidity is invariably a dead exchange as the liquidity can be compared to the oxygen needed for a human to survive. The liquidity is needed for the exchange to survive.
For the DEX, the liquidity pool is translated into Automated market makers (AMM). This AMM enables the exchange to trade in an automated manner using a protocol to facilitate such transactions efficiently.
Liquidity pools for decentralized exchanges are designed to incentivize users of different crypto platforms, who are called liquidity providers (LPs) and after several transactions, the LPs are rewarded with a fraction of fees from the various transaction with other incentives, equivalent to the amount of the liquidity they have supplied.
Several decentralized platforms capitalize on the use of automated market makers to create liquid pools which are used for permitting digital assets to be traded in an automated and permissionless way.
Consequently, these popular platforms ensure that they center their operations on liquidity pools to help them grow their business.
In conclusion, liquidity pools are a new window of opportunity for investors and users alike. Such that the users can have access to easily trade the tokens or coins in a decentralized exchange due to the availability of liquidity in such exchanges.
While the investors can benefit from the opportunity by simply providing liquidity in the exchange for a fraction of the transaction fees and other incentives.