Financial services are generally based on transfer of funds between parties. For example, when we borrow money from banks that money is deposited by someone. They earn interest for depositing their money, and we pay interest on the loan. The money moves between the depositor and borrower through the bank. On a larger scale, many people deposit money at the bank and the bank then lends that money to potentially many borrowers.
This involves the bank to manage large amount of currency, which, in turn, allows the bank to provide several financial services (forex, etc.). The bank basically pools money from many depositors to create a liquidity pool. The bank is also a centralized service provider.
Now let’s try to apply the same concept to decentralized systems. To provide financial services using decentralized applications — also known as DeFi or Decentralized Finance — users deposit (lock) their tokens in smart contracts to help create liquidity pools. Borrowers then borrow these tokens as loans and pay interest. Depositors earn interest for locking their tokens.
Liquidity pools are the basic building blocks and enablers for financial services in the DeFi space. In addition to simple lending, liquidity pools are also used in decentralized exchanges for token swaps. In such setting, the pools are maintained in token pairs so that users can easily swap or exchange their tokens with other tokens. The fee charged for the swap is (partly) distributed among the pool contributors/depositors.
The term for earning from contributing to liquidity pools is called Yield Farming. Users lock their tokens or token pairs in DeFi smart contracts and, in return, earn tokens. These could be some percentage of the same tokens and/or DeFi app specific tokens. Several DeFi apps provide features and strategies for users to maximize their yield by locking their tokens in multiple pools.
Episode 27 - Liquidity Pools, Swaps, and Yield Farming