What is Liquidity Pool and Yield Farming? How do they work?

Charlie Taylor

Liquidity and yield farming pools have become important issues when it comes to decentralized finance, blockchain and disruptive technologies. In this text we will explain everything you need to know about how these new ideas work.

What are liquidity pools on the blockchain?

A liquidity pool is a set of tokens that are stored in a smart contract. It is used to provide liquidity to the market, mainly for decentralized brokers. Users of these pools leave their money locked up and receive rewards for risk and money invested. But before we explain the intricate workings of liquidity pools, we need to understand what they are for. They were created as an alternative way to replace the traditional offer book model of centralized exchanges. In this order book model, buyers and sellers place thousands of orders together, where the seller seeks the highest possible price and the buyer the lowest, the trade happens when the two parties converge on the price. Bovespa (B3), Binance, Foxbit and Novadax use this method.

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This model also needs people who provide liquidity to the market, buying and selling assets to make the life of the common investor easier. However, these market makers execute thousands of orders and the level of transactions executed by a blockchain like Ethereum is only 15 per second, being unable to handle this demand. Hence the liquidity pools.

How do liquidity pools work?

In their most basic form, liquidity pools have only 2 tokens, let us say they are TUSD / ETH tokens. They are added by the pool creator and liquidity provider, who therefore sets the starting price. ” alt=”liquidity pool creation” width=”276″ height=”224″ />If the starting price differs from the market price then there is an opportunity for arbitrators. Let’s say the initial price of the pool is 1 ETH to 2,000 TUSD, if the ETH price is $ 2,274 on Novadax the arbitrator can add more TUSD to the pool and withdraw ether to sell on the centralized exchange, until such divergence there is no more. This is because the pool protocols automatically adjust the price according to the ratio between demand and demand, called the deterministic price algorithm. This entire process of buying, selling and creating liquidity is called an automatic market maker (AMM). The algorithm ensures that the pool always has liquidity, regardless of the size of the order, as the algorithm increases the price of the token asymptotically.

How to participate in a liquidity pool?

To participate in a liquidity pool it is necessary to have 2 tokens, such as BNB and BUSD. In this post we use Pepper Finance, which uses Pancake Swap pools on Binance Smartchain. Notice in the image below the relation between BUSD by BNB, which is equal to 516,527. You can add two values ​​proportional to the relationship between the tokens to add liquidity to the BNB / BUSD pool and in return you will receive between 1% to 0.3% of the trade fees according to your percentage participation, the more money invested the greater the participation. Another thing you get are Liquidity BNB / BUSD (LP – BNBBUSD) tokens that represent your investment. These liquidity tokens can be used in stakings to generate rewards on other assets, they are the well-known FARM tokens.” alt=”LP farming at Pepper” width=”-1″ height=”-1″ />Such tokens, like Pepper, Corn and others are extremely volatile, which leads many “liquidity farmers” to rotate their farm tokens. Yields are called yield farming and are essential for a good strategy for liquidity providers.

Risks of providing liquidity

Of course, there are several risks when it comes to providing liquidity in smart contracts. First, there is a risk of vulnerability in smart contracts, which can lead to irreversible hacks. Another risk is that there are bugs in the code, which can lock up liquidity providers’ funds and have other negative consequences. Finally, there is a systematic risk of losses in cases of price manipulation and sudden drops in one of the tokens in the pool.

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