In one of our previous posts, when decoding what Automated Market Makers (AMMs) are and how they operate, we already briefly grazed the topic of Liquidity Pools and Liquidity Providing. Today, however, we will share a more in-depth look at this feature that plays such an important role in empowering the decentralization of finance.
Liquidity pools were conceived as a solution for the liquidity challenge in Decentralized Exchanges (DEXs). With them, it was finally possible to successfully replace the order book model used in centralized exchanges and traditional financial markets. Today, there are countless platforms that rely on this solution and an even greater number of users that both contribute and benefit from them.
Liquidity Pools and Liquidity Providing
In their essence, liquidity pools are, quite literally, pools of tokens that are locked in a smart contract and users can trade against. In most cases, Liquidity Pools hold two different tokens that form a trading pair in the smart contract.
To participate in a liquidity pool, liquidity providers must contribute with an equal amount of both tokens held in it, so that when someone wishes to trade one asset for the other, they can do so using the existing funds in the pool instead of needing a trading counterparty.
Healthy liquidity is crucial for liquidity pools as it prevents slippage. Therefore it is essential for any platform relying on liquidity pools to attract as much liquidity as possible, and, since liquidity is created exclusively by liquidity providers, it is essential for these platforms to attract and look after them.
As such, liquidity providers are rewarded for their contributions. In most cases, these rewards arrive in the form of a percentage of the fees of all transactions carried out inside the pool. In other words, every time someone buys or sells a token using a liquidity pool, all the liquidity providers receive a part of the trading fee in proportion to their stake.
In a way, liquidity providing can be viewed as a form of staking, as liquidity providers lock their assets in a smart contract for a fixed amount of time in exchange for a reward, and, just like staking, liquidity providing can be a great way of generating passive income.
Closing Thoughts
Liquidity providing made DeFi possible, and it is a very functional solution for assuring liquidity in decentralized platforms. It is also, like we mentioned earlier, a great way of extracting passive income from your owned assets. However, there are also some risks associated with becoming a liquidity provider.
The one that has the biggest significance is the risk of suffering an impermanent loss. This happens when one of the two tokens submitted to the pool suffers a significant price drop and disturbs the balance of the pool. In these cases, you may end up withdrawing a smaller amount of your assets than the initially deposited. The risk of Impermanent Loss can be reduced, however, by pairing assets with similar prices or by using less volatile assets, such as stablecoins
About Solanax
Solanax is a Solana-based automated market maker (AMM) exchange providing lightning-fast trades, pooled liquidity, and other income-generating features. Solana was chosen as the underlying blockchain to facilitate low-cost, high-speed transactions. It is a permissionless, high-performance blockchain based on the Proof of History consensus (PoH).
Given the advantages that Solana offers when compared to other blockchain ecosystems, it is a popular solution among investors, users, and developers. Ethereum’s Proof of Work Consensus is slow, hard to scale, and comes with high gas fees which were exacerbated by its account-based system. Where Ethereum has failed to live up to the community expe, Solana quickly proves to be a viable alternative.
Solanax will utilize the cross-bridge Wormhole to connect to projects and digital assets existing on the Ethereum blockchain, facilitating adoption and allowing the crypto community to seamlessly move tokenized assets from one blockchain to another, improving interoperability and liquidity setup.
It is faster and cheaper; Solanax offers on-chain liquidity; traders will have more control over their trading activities; an integration of Wormhole for fusion with tokenized assets on the Ethereum blockchain, and much more.
For more details on the project at the forefront of the DeFi evolution, visit:
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