Picture a highway at rush hour. Liquidity is like having all lanes open and flowing freely. Traffic moves smoothly, everyone reaches their destination efficiently, and there are no frustrated drivers. Illiquidity, on the other hand, is like having most lanes closed for construction. Traffic crawls, tempers flare, and it takes forever to get anywhere.This is kind of what decentralized exchanges (DEXs) are like in the world of cryptocurrency. But how do these DEXs allow for smooth flowing without the need for a central authority? The answer lies in liquidity pools.
In a traditional exchange, buyers and sellers are connected through an order book. This book lists buy and sell orders at various prices. However, DEXs don't rely on order books. Instead, they use liquidity pools, which are like communal pots of cryptocurrencies locked in smart contracts, self-executing agreements that govern the rules of the pool.
In this article, we cover how Liquid Pools work, its pros and cons, and where you can find some that accept Sceptre Staked Flare (sFLR).
How Liquidity Pools work
Anyone can contribute to a liquidity pool by depositing their crypto assets, usually in trading pairs. These contributors are known as liquidity providers (LPs). These combined assets provide liquidity, essentially acting as a reserve for other users to trade against. In return for contributing their assets, LPs earn a portion of the fees generated from these trades. This system creates a win-win situation: users benefit from a smooth and efficient trading experience, while liquidity providers are rewarded for keeping the market active.
When a trade occurs on a DEX, the AMM (automated market maker) algorithm uses the liquidity pool to complete the transaction. AMMs rely on formulas to determine the price of the assets being traded based on the ratio of each asset in the pool.
What are the benefits of Liquidity Pools
For a DEX, liquidity pools are essential for them to function. They ensure that there are always buyers and sellers available, enabling smooth and efficient trading.
For LPs, liquidity pools generate yield through trading fees that go to them. It goes without saying that Liquidity Pools also play a major role in making DeFi more accessible since anyone can become a liquidity provider.
What are the risks associated with Liquidity Pools?
When providing liquidity to a liquidity pool, users should be aware of the general DeFi security rules we outlined in this article.
Additionally, they should be aware of the risk of Impermanente Loss, which doesn’t deal with security but with liquidity.
Impermanent Loss occurs when the price of the assets in a liquidity pool changes significantly compared to when they were deposited. To maintain a balanced ratio of the two assets in a liquidity pool, AMMs constantly rebalance the pool based on trading activity. If the price of one asset increases dramatically compared to the other, the protocol will sell some of the appreciating asset to buy more of the depreciating one.
When you withdraw your liquidity, you'll receive your share of the pool's assets. However, due to the rebalancing, you might end up with fewer of the appreciating asset and more of the depreciating one compared to if you had simply held the assets outside the pool. This discrepancy is called impermanent loss. The more volatile the assets, the higher the potential for impermanent loss.
Impermanent loss is temporary and only becomes a realized loss when liquidity is withdrawn.
Can sFLR be used in Liquidity Pools?
Sceptre Staked Flare (sFLR), the token you receive in your wallet for staking Flare (FLR) or Wrapped Flare (wFLR) on Sceptre, can be used in Liquidity Pools available on Ēnosys and BlazeSwap. There are several trading pairs available at both exchanges.
Overall, liquidity pools are a fundamental building block of DeFi. They enable DEXs to operate efficiently and provide opportunities for users to earn yield. However, it's important to understand the potential risks involved before becoming a liquidity provider.
We will keep updating this article as more Liquidity Pool opportunities for sFLR appear.