What are liquidity pools?

What are liquidity pools?

Liquidity pools, in simple terms, are a collection of tokens that are locked in a smart contract. They enabledecentralised lending, trading, and other functions by providing liquidity. Liquidity refersto the ease with which a coin can be converted into cash or other coins.

Liquidity Pools are an essential part of the DeFi ecosystem. They providethe basis for many decentralisedexchanges (DEXs).

What are liquidity pools?

With the growth ofDecentralised Finance (DeFi), we’ve seen an explosionof on-chain activities. One of the main technologies behind theecosystem is the liquidity pool.

A liquidity pool isa crowdsourced pool of tokens locked in a smart contract. They’re used tofacilitate trades on a decentralised exchange. Instead of traditionalmarkets of buyers and sellers, many DeFi platforms utilize automated marketmakers (AMMs) to allow for automatic, permissionless trades of digitalassets through liquidity pools.

In return forproviding liquidity, the liquidity provider (LP) is rewardedwith special LP tokens in proportion to the liquidity they provided.When a pool facilitates a trade, a trading fee is distributed amongst all LPtoken holders in proportion to their share of the total liquidity.

Why are they necessary?

Centralised exchanges(CEXs) like Coinbase and Binance and traditional stock exchanges usethe order book trading model. In this model, for a tradeto complete, the buyer and seller must converge on the price. Market makersfacilitate trading by providing liquidity and by always being willingto buy or sell a certain asset.

However, DeFi trading needs tobe executed on-chain, without a centralised intermediary. And, as eachinteraction with the order book comes with a gas fee, it’s much more expensiveto complete trades. Blockchains also can’t handle the throughput required fortrading billions of dollars each day.

So, it’s almost impossible fora blockchain like Ethereum to operate on an on-chain order book exchange.(However, there are some DEXs that do work with order books.)

How do they work?

Automated Market Makers enableon-chain trading without the need for a direct counterparty to complete trades.Instead, you are completing the trade againstthe liquidity pool’s liquidity. So, as long as there’senough liquidity in the pool, the buyer can buy, even if there’s noseller present at that particular moment.

What are they used for?

We’ve already discussed AMMsas being one of the main uses of liquidity pools. However, they’realso used in a number of other ways such as yieldfarming or liquidity mining. Liquidity pools are thefoundation of platforms like Yield, where participants deposit funds to poolsthat are used to generate yields.

Risks

As with mostthings, liquidity pools are not without risks. It’s important to beaware of risks like impermanentloss, liquidity pool hacks, smart contract bugs andsystematic risks. Impermanent loss occurs when youprovide liquidity to a liquidity pool but the price of yourdeposited assets alters compared to when they were deposited.

Examples of liquidity pools

Popular exchanges thatutilize liquidity pools include SushiSwap, UniSwap,and PancakeSwap.

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