Understanding liquidity pools and AMMs for DeFi trading

What are liquidity pools and AMMs and how do they work for decentralized finance trading?

The DeFi (decentralized finance) sector is steadily changing the cryptocurrency landscape by simplifying the decentralized exchange (DEX) architecture and allowing any exchange built on it to use liquidity pools. 

The following is an introduction to liquidity pools and automated market makers (AMMs)— some of the most appealing features offered by the DeFi sector right now.

What is liquidity?

First, let’s define the term “liquidity” and why it’s an important metric for market traders. Liquidity refers to the ease with which we can convert an asset into cash at its current market value.

Asset liquidity is critical for traders. High liquidity means faster transaction settlement. A delayed transaction can lead to a loss of profits, if the asset’s value falls before the transaction completes. We commonly refer to this type of loss as “slippage” — the price difference between what you expected to pay and what you did pay. 

While traditional market makers must constantly monitor and adjust their buy orders to avoid slippage, DeFi exchange protocols aim to solve the problem of slippage, among other problems, through the use of decentralized liquidity pools and AMMs.

What are liquidity pools?

A liquidity pool is an investment tool aimed at providing liquidity for one or more digital assets. These marketplaces enable other DeFi protocols to swap or liquidate tokens as needed. The greater the pool’s assets and liquidity, the faster and easier it is to trade on decentralized exchanges.

Liquidity pools incentivize liquidity providers to stake tokens at risk to provide liquidity to otherwise unexchangeable tokens. When a user liquidates their token asset holdings, smart contracts automatically distribute the exchange fees to the pool’s liquidity providers in proportion to the overall liquidity staked in that specific pool.

By decentralizing liquidity in the crypto market, DeFi exchanges or DEXes remove traditional counterparty risks by eliminating the need to rely on a central custodian to facilitate and potentially manipulate transactions. Instead, smart contracts are used to execute transactions either peer-to-peer or against a liquidity pool.

Liquidity pools do not need to aggregate data from multiple exchanges to determine asset prices. To determine the exchange rate, smart contract-based liquidity pools determine an assets’ value automatically, so that the token price remains relative to the ratio of the collateralized token held in the pool’s reserve.

How do automated market makers (AMMs) work?

AMM is a smart contract-based liquidity pool that operates under full decentralization, expunging the need for order books and traditional market makers.

Users are no longer required to fund their accounts via a centralized exchange. Rather, they maintain total ownership of their assets for the duration of the transaction.

Market makers create liquidity pools in which smart contracts balance asset pricing based on the current market supply and demand. If a user wishes to exchange token X for token Y, for example, they may submit a trade request to the smart contract. The smart contract will compare prices from all available liquidity providers, accept the best offer, and execute the deal on the user’s behalf.

An AMM lending protocol establishes a link between customers and liquidity providers and enables atomic settlement and efficient execution. Interest rates on pooled loans fluctuate based on supply and demand. All borrowers pool funds into a single smart contract-based lending pool and lenders earn interest as soon as they deposit their funds.

The pool’s utilization rate affects interest rates. Loans become less expensive when liquidity is plentiful. When loans are in great demand, they become more costly. DeFi loan pools enable maturity and size transformation while keeping high liquidity for individual lenders.

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