What are liquidity pools and how do they work?
Liquidity pools, in simple terms, are a collection of tokens that are locked in a smart contract. They enable decentralized lending, trading, and other functions by providing liquidity. Liquidity refers to 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 provide the basis for many decentralized exchanges (DEXs) like Uniswap. Let’s take a closer look.
What are liquidity pools?
With the growth of Decentralized Finance (DeFi), we’ve seen an explosion of on-chain activities. One of the main technologies behind the ecosystem is the liquidity pool.
A liquidity pool is a crowdsourced pool of tokens locked in a smart contract. They’re used to facilitate trades on a decentralized exchange. Instead of traditional markets of buyers and sellers, many DeFi platforms utilize automated market makers (AMMs) to allow for automatic, permissionless trades of digital assets through liquidity pools.
In return for providing liquidity, the liquidity provider (LP) is rewarded with special LP tokens in proportion to the liquidity they provided. When a pool facilitates a trade, a trading fee is distributed amongst all LP token holders in proportion to their share of the total liquidity.
Why are they necessary?
Centralized exchanges (CEXs) like Coinbase and Binance and traditional stock exchanges use the order book trading model. In this model, for a trade to be complete, the buyer and seller must converge on the price. Market makers facilitate trading by providing liquidity and by always being willing to buy or sell a certain asset.
However, DeFi trading needs to be executed on-chain, without a centralized intermediary. And, as each interaction with the order book comes with a gas fee, it’s much more expensive to complete trades. Blockchains also can’t handle the throughput required for trading billions of dollars each day.
So, it’s almost impossible for a 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 enable on-chain trading without the need for a direct counterparty to complete trades. Instead, you are completing the trade against the liquidity pool’s liquidity. So, as long as there’s enough liquidity in the pool, the buyer can buy, even if there’s no seller present at that particular moment.
What are they used for?
We’ve already discussed AMMs as being one of the main uses of liquidity pools. However, they’re also used in a number of other ways such as yield farming or liquidity mining. Liquidity pools are the foundation of platforms like Yield, where participants deposit funds to pools that are used to generate yields.
Risks
As with most things, liquidity pools are not without risks. It’s important to be aware of risks like impermanent loss, liquidity pool hacks, smart contract bugs, and systematic risks. Impermanent loss occurs when you provide liquidity to a liquidity pool but the price of your deposited assets alters compared to when they were deposited.
Examples of liquidity pools
Popular exchanges that utilize liquidity pools include SushiSwap, UniSwap, and PancakeSwap.
