Decentralized Finance (DeFi) has changed the way people handle assets in the crypto market since its inception. Only after the introduction of DeFi. Users can understand what it means to actually keep their property safe. We recommend reading the DeFi guide for more information.

 For many years, we have held crypto assets on one of the centralized exchanges (CEX) such as Binance, Coinbase and FTX. These are great options for monetizing money, but it’s a nightmare when you consider that security risks  expose us. A centralized exchange stores your funds. This means that  if  a security breach occurs on the platform, we can all lose money.

 DeFi only saves us from being exposed to this risk. But what made the DeFi ecosystem possible?

 It is called the liquidity pool. The  Liquidity Pool serves as the backbone of all DeFi platforms, whether they are decentralized exchanges (DEX) such as Uniswap or Sushiswap. Credit platforms such as Maker, Compound and AAVE. Or a synthetic asset platform such as Synthetix or Mirror Protocol. The possibilities you can build with this ecosystem are endless. In , let’s understand what a liquidity pool is and how it powers the DeFi platform.

 What is a liquidity pool?

A liquidity pool is a collection of funds locked into a smart contract on the DeFi platform, where anyone can deposit  assets and receive rewards by providing liquidity to the platform. Let’s do this using the  example of a decentralized exchange (DEX). NS. Uniswap, please understand.

 Liquidity pool 1

Anyone can provide liquidity to Uniswap by adding funds to Uniswap’s liquidity pool. The person depositing the asset is known as a liquidity provider.

 In addition, traders use Uniswap to buy and sell crypto tokens, and in return Uniswap charges transaction fees. Uniswap distributes this transaction fee to liquidity providers as a reward for providing liquidity to the platform.

 Liquidity pool 2

Therefore, liquidity pools are an important part of any DeFi platform. Now let’s dig deeper into the components of the liquidity pool.

 What are the components of the liquidity pool? The various components of the liquidity pool are:

1. Liquidity provider

A liquidity provider is a person who pays an asset to a particular liquidity pool to provide liquidity to the platform. For example, a person can become a liquidity provider in Uniswap (Distributed Exchange (DEX)) and deposit  assets in Uniswap’s liquidity pool.

 Exchanges typically issue derivative tokens as receipts for deposited funds. In Uniswap, these tokens are called LP tokens (liquidity provider tokens). These LP tokens are either burned or traded like a public market to remove liquidity from the platform.

 The term liquidity provider is a general term and can be used differently on  different platforms. For example,  lending platforms call them lenders.

 In addition, the types of rewards liquidity providers receive will vary by platform. For example, in DEX, liquidity providers receive a portion of the transaction fee. However, the lending platform receives a portion of the interest received from the borrower.

 The next component is the pool itself.

2. Pool of funds

 A liquidity pool is a collection of assets that a liquidity provider can deposit for use on the platform. The structure of the liquidity pool may vary from platform to platform.

Example:   lending platform uses a single asset pool. The pool consists of only one asset. DEX typically uses a dual asset pool. This makes it a complete market for certain asset pairs such as BTC / USDT, ETH / DAI. Some platforms use a pool of  up to 8 assets. Therefore, the structure of the pool is determined by the platform itself.

 Consider how some of these platforms use their respective pools.

3. Types of platforms that use liquidity pools

 Many different decentralized platforms use liquidity pools to provide liquidity to logs, which can be broadly categorized as follows:

 Loan Platform-(Liquidity Pool of Individual Assets) Liquidity pool of individual assets The loan platform is a simple decentralized credit and credit market. Use a single asset liquidity pool. For a single asset liquidity pool, the pool consists of only one asset.

 As you can see in the picture above, Compound has a liquidity pool of DAI tokens. Anyone who wants to lend a DAI token can deposit  the token in the DAI pool via the protocol. In this case, the lender does not communicate with the borrower, but this transaction takes place between the lender and the smart contract.

 The lender deposits his DAI token and receives a cToken (cDAI in this case). cTokens can be understood as  receipt of DAI tokens deposited by the lender. If the lender pays with ETH, he will receive cETH.

 cToken is a form of derivative that derives its value from the basic assets deposited by the lender. The value of these cTokens will increase over time as  the amount of interest accumulates.

 From the borrower’s point of view, the borrower receives the cToken and sets collateral to get the loan in return. As you can see in the picture above, the borrower receives ETH as collateral and  DAI as a loan and cETH. Transactions between the borrower and the smart contract are also made with the borrower.

 Now let’s understand the structure of a  liquidity pool with two assets.

Decentralized Exchange (DEX) – (Two Asset Liquidity Pool)

Dual Asset Liquidity Group As stated above, Uniswap is one of the decentralized exchanges (DEX) used to buy and sell crypto tokens. Since Uniswap does not have an order book like a centralized exchange, orders are executed from different liquidity pools created on the platform.

 The Cash Pool on Uniswap consists of 2 tokens. As you can see in the image above, there is an ETH/DAI pool. Uniswap’s internal algorithm called  Market Maker automatically decides the rate at which two tokens will be deposited into the pool.

 How does the Automated Market Maker work?

 Base The Uniswap AMM price of an asset is determined based on the token supply in the respective liquidity pool. For example, in the ETH/DAI pool, there are 20 ETH and 60,000 DAI.  ETH price = 60,000 / 20 = 3,000 DAI. Thus, the value of the total ETH in the pool is $60,000, and the total DAI in the pool is also worth $60,000. The

 AMM algorithm guarantees and adjusts asset prices so that the asset value ratio  is always 1:1. For example, let’s say the Automated Market Maker (AMM) base price is 1 ETH = 3,000 DAI. Then a liquidity provider will only have to deposit his tokens at this rate, that is, if he wants to deposit 5 ETH, he will have to deposit 15,000 DAI  with it. Each cash fund on Uniswap acts as a separate market for that particular currency pair.

 In return for providing liquidity, Uniswap will provide LP tokens (liquidity provider tokens) to the liquidity providers. In addition, these LP Tokens can also be staked for additional rewards.

 When a trader trades their tokens on Uniswap, they return a commission to Uniswap, which is then distributed to the liquidity pool. As a result, liquidity pools keep these platforms running smoothly.

 The most popular DEX and Lending Platforms are:

Now let’s understand how we as HODLers can earn  passive income through cash fund.

 How can you earn passive income from cash fund?

As a HODLer, we can choose a specific platform and give it liquidity. In return, the platform will share its earnings with us. So, based on the platforms described above, there can be

• You can become a lender on lending platforms
• You can become a liquidity provider on the DEX

Additionally, in addition to revenue sharing  with  liquidity providers, DeFi platforms are also reducing their internal tokens. This is called liquidity mining.

 Let us now summarize the advantages of a liquidity pool.

 What is the advantage of liquidity pool?

The  liquidity pool advantages are as follows:

1. The liquidity pool helps a DeFi platform by providing liquidity
2. The liquidity pool makes it possible for a decentralized ecosystem to work without an order book like centralized exchanges
3. Cash funds are a very attractive way for HODLers to earn passive income

 However, we cannot ignore the possible risk  of liquidity pools.

 What are the risks and limits of the liquidity pool?

Possible limitations of the liquidity pool are as follows:

1. The small liquidity pool always makes the traders in the DEX more prone to slippage.
2. The liquidity provider is subject to the risk of Impermanent Loss in the event of a substantial change in the price of the deposited asset.

Conclusion

Inference I understand that liquidity pools are still in the innovation phase, but they are  essential to the entire decentralized ecosystem. As they grow, platforms will depend more  on them.

 Also, as a HODLer, they seem to be a lucrative way to earn passive income. You can try starting with Uniswap and then explore the rest of the platform. My Uniswap tutorial will be helpful for this.

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