It’s not weird seeing smart contracts and liquidity pools in one sentence; it means DeFi is somewhere around the corner. So, what are smart contracts? They are digital contracts on the blockchain, automatically executed without a third party after pre-coded terms have been met. It’s simpler to assimilate when you think about the Ethereum network since it’s the first to house smart contracts, which goes for liquidity pools. The Ethereum network, a second-generation network, provides users with the capacity to house applications that use smart contracts instead of financial intermediaries. So, in a nutshell, smart contracts are developed to eliminate financial intermediaries and execute the true intent of decentralization.
How do smart contracts work?
As mentioned above, smart contracts are such that they get rid of financial third parties and intermediaries. They work based on predetermined codes, which contain the “ifs and whens” statements. Note that with smart contracts, it’s a network of computers working together as one to execute these processes once the terms have been met. Some of these actions could be confirmation of funds, sending a bunch of notifications, vehicle registrations, or even issuing a ticket, amongst others. It is, however, essential to note that once these codes have been successfully deployed, they cannot be changed or uttered, and results are only available to trusted parties or those that have been granted permission.
So, there are various codes pre-written within a smart contract to accommodate as many stipulations as possible. So, in other for the terms to be established, participants must be sure their data as represented on the network is in line with the predetermined codes. Smart contracts are programmed by developers, although large organizations that use blockchain provide templates and interfaces of how their smart contracts should be structured.
What are liquidity pools?
As mentioned above, liquidity pools and smart contracts only lead to the DeFi ecosystem. So, it’s impossible to discuss liquidity pools without explaining DeFi. DeFi is an ecosystem of decentralized finance blockchain applications that use smart contracts to eliminate financial intermediaries. In the DeFi ecosystem, we have important players such as the DEXs, liquidity providers, stablecoins, Yield farming, etc. Hence, liquidity pools are crowdfunded funds locked in a smart contract that provides liquidity for DEXs, borrowing and lending platforms, and other DeFi applications.
So, it’s impossible to have liquidity pools without a smart contract, and they both encompass what forms the DeFi ecosystem, amongst other vital factors. Liquidity providers are important market participants that provide liquidity, i.e., they use their crypto assets to provide trust for the protocol to function and transactions to be stress-free. Being a liquidity provider or becoming one means you’d have to sacrifice your holdings and act as a backbone. However, one of the perks of being a liquidity provider is that you’d be incentivized with a percentage from the transaction fee accumulated on the DEX. The incentive will be a proportion of the liquidity you’ve provided.
How does the liquidity pool work?
It’s straightforward than when compared to the centralized system. Anybody can be a liquidity provider on DEX. All you need do is deposit into the liquidity pool and receive incentives in the form of a transaction fee proportional to your provided liquidity. For these funds, liquidity allows all forms of transactions, so instead of transacting against other users and market makers, you transact against the liquidity. The liquidity pool uses algorithms that help determine the price of assets according to the trades on the pool. This algorithm enables the pool to maintain liquidity by increasing the price as the demand for the asset increases.
Smart contracts and liquidity pools work in proximity for the smooth running of DEXs in the DeFi community. There would be no DEX (decentralized exchange) without liquidity pools, and liquidity providers since the liquidity providers are the backbones. However, liquidity pools won’t be achieved without a smart contract. Hence, both parties are essential in keeping the DeFi ecosystem running smoothly. Although there are other means of making passive income in the DeFi ecosystem, liquidity provision seems to be one of the easiest with minimal risk. To provide liquidity, you need to be willing to sacrifice your crypto, which means you need to understand the project and be sure it’s worth the risk. Because as many individuals begin to transact using the project, the more you earn. So, be the first, if you have a project, provide enough liquidity for the project because it’s also a means of knowing which project is safe to invest.