The Importance of Liquidity Pools in DeFi

What are Liquidity Pools?

Why Are They Important?

  • Automated market makers: Decentralized exchanges like Uniswap, Curve, and PancakeSwap popularized decentralized liquidity pools, where anybody can provide the liquidity that traders can use to complete their token swaps. Without these liquidity pools, AMMs would be relegated to using centralized liquidity providers or suffer from low liquidity, defeating their purpose as decentralized exchanges.
  • Cross-chain bridges: Cross-chain bridges are increasingly turning to decentralized liquidity pools as a way to maximize liquidity for cross-chain asset transfers while boosting the utility of idle assets. Indeed, platforms like zkLink and ChainSwap allow users to contribute their assets to the protocol’s liquidity pools and earn a fraction of the cross-chain fee in return.
  • Open lending protocols: The last few years have seen the advent of a variety of open lending protocols like Compound and Aave which use decentralized liquidity pools and smart contracts to automatically provide collateralized loans to borrowers and share any interest among liquidity providers. This enabled the first wave of decentralized competitors to platforms like Nexo and Celsius, and many open lending protocols now form a crucial part of additional DeFi infrastructure — including yield aggregators like Autofarm and yield optimizers like Yearn Finance.

The Dangers of Impermanent Losses

Image courtesy: Topaze Blue

The Role of Yield Farms

  • Increased exposure: Yield farms are a way to expose liquidity providers to new projects that might interest them. In turn, some of these users will likely go on to invest in the project token, helping to support its value, and may even become liquidity providers — helping to maximize liquidity for the token. Project tokens that offer a high yield can attract significant press coverage, word-of-mouth, and KOL marketing, helping to further grow its userbase. That said, if this high yield causes excess supply, it can have detrimental effects on the token’s valuation — this is extremely common.
  • Wider distribution: Many projects are looking to increase the number of token holders, both in order to reduce centralization, and to later convert as many of these holders to product users as possible. Yield farms can allow a project to distribute its tokens to potentially tens of thousands of active users with ease. This is particularly important where the reward token is used for governance since it can increase community participation and reduce the chances of monopolization.
Image courtesy: PancakeSwap

Conclusion

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