I will explain the decentralized finance ecosystem, better known as DeFi, that exists today in the crypto industry, to get a clear picture of what will develop in Cardano.
DeFi is growing at an unprecedented pace, and today the total value locked in exceeds U$S 40 billion, mainly through liquidity pools and lending protocols.
The Cardano community awaits the latest hard fork (Alonzo) to complete the arrival of the Goguen era, and if all goes well, in August 2021 Cardano will be programmable.
Cardano has liquidity in abundance. Unlocking this liquidity will be one of the most important functions for decentralized financial applications.
In this regard, liquidity pools play a crucial role. They are cryptocurrencies (tokens) that are locked into a smart contract, to facilitate trading, creating an automated market that provides liquidity, which prevents large price swings of an asset.
Liquidity pools use algorithms called Automated Market Makers (AMM) to provide constant liquidity for trading.
They are widely used by decentralized exchanges, DEX, and are used with tokens that lack liquidity, due to their low volume.
In contrast, traditional exchanges operate using an order book model, because there is sufficient liquidity due to the number of buyers and sellers.
A single liquidity pool contains a pair of tokens, and each pool creates a new market for that particular pair of tokens. The first depositor in the pool, or liquidity provider, sets the initial price of the pool’s assets. Liquidity providers are incentivized to supply an equal value of both tokens to the pool. They receive special tokens, called LP tokens, in proportion to their contribution to the pool.
When a token exchange occurs through a pool, the supply of one asset decreases while the supply of others increases. Therefore, price changes occur, which are adjusted by the AMM algorithm. Liquidity providers simply deposit their assets into the pool and the smart contract takes care of the pricing.
Then, liquidity mining is a strategy by which DeFi protocols seek to capture the attention of users by granting rewards in the form of tokens that can be exchanged on or off the platform, or simply “hodl” them, and receive better profits with the increase in the value of those tokens received.
The liquidity mining craze is fairly recent, with many attributing it to Compound since June 2020, with its COMP governance token.
One of the newest DeFi protocols is Yearn Finance (YFI), or yield farming, in Ethereum’s DeFi ecosystem, which is a platform intended for investors looking to increase returns, through automated exchange between different liquidity pools.
As with any investment platform, Yearn Finance has advantages and risks, it is extremely simple to use, constantly evolving and enjoys great transparency, as all smart contracts are on GitHub. It has great liquidity, which means that other projects open doors for its integration.
On the other hand, among the risks are that sometimes the Vaults have a debt, and if a certain level is exceeded, the assets within it are blocked. In addition, the protocol is highly dependent on other platforms that may have serious security or liquidity issues and this makes Yearn Finance a point of amplification.
Finally, there is a tool to increase liquidity even further, and that is interoperability between blockchains, with cross-chains, which are bridges between different blockchains in the format of smart contracts that function as token wrappers. They are many and varied, the most prominent today being (wrapped) wBTC, an Ethereum token tied to the value of BTC.
Cross-chain can be decentralized, they are based on a game-theoretic protocol design, while centralized ones rely on the trust placed in the custodian system operator.
Cross-chains are important for the long-term prosperity of multi-asset blockchain networks, and are critical to increasing the on-chain liquidity of such networks.
This is the outlook that awaits Cardano, which is poised from its design, to develop the best financial system on a global scale.
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