As a newbie who just discovered what the defi is, am sure things are still blurry to you. It’s understandable because your brain is still trying to assimilate lots of information. Whenever I want to invest in anything, I try to understand the mechanism in which the thing works so I don’t feel like an ignorant person that puts money somewhere and expect magic to happen without knowing how it works.
First of all you need to understand that for DEFI to work, they need to be liquidity. You know it’s decentralized, it’s not centralized and most of its action are based on smart contract. So for the ease of converting your crypto, coins or token to cash, there need to be liquidity. If liquidity is absent then you just have a valueless token or rather a useless smart contract.
It’s almost impossible to find a defi without liquidity pool, and understanding liquidity pool is the key to understanding where you are putting your money. So liquidity pool is locking your money in the blockchain’s smart contract by providing liquidity to enable easy exchange or something I will call easy trade in the defi platform. If liquidity isn’t provided then there won’t be trading in the platform. This provision of funds or liquidity is usually crowdsourced, this means that it’s done by a large number of people.
I believe you must have used a centralized exchange before and if you are observant you will notice that centralized exchanges have lots of orders booked, it utilizes the order book trading model. The way it works is that, a seller list the price it wants to sell a token, a buyer needs to agree on the price the seller is willing to sell. When they both converge on the price simultaneously, the order is executed, and because of the rate at which people are always placing and executing orders, this actions are implemented instantly.
But on DEFIs it’s different, the system uses a AMMs which means Automated Market Makers. This method enables smooth trading without the filling of order books. As long as liquidity has been provided transactions are executed instantly. The pool enables you swap your token for cash even when there is no order placed by a seller or a buyer. The pool just provides the liquidity for you effortlessly.
Whenever transactions are executed on Defis, a gas fee is required from any one trying to execute a transaction. This gas fee is shared amongst all Liquidity Provider in the form of the native liquidity pool token. For instance, if you provide liquidity in the liquidity pool of Pancakeswap you will get rewarded in Cake token. But we are concentrating on cubdefi so the reward is in cub tokens.
This is the blockchain rewarding you for providing liquidity in the liquidity pool. But just as this sounds interesting and is decentralized, you should know that there are risk involved. The risks involved are hacks, impermanent loss and smart contract bugs. This year we saw a great number of Defis get hacked through smart contract bugs. As a user there is nothing you can do about it, the security of the defi platform has to depend on the efforts of the developers. This is why you need to do your own research on which defi platform to use. I personally use cubdefi, not a financial advise though.
It’s also right you understand impermanent loss and the risk involved in liquidity pool. Impermanent loss is the possible loss that will occur when volatility affects the tokens provided as liquidity.
Posted Using LeoFinance Beta
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Posted Using LeoFinance Beta