DeFi Learning: What Is a Liquidity Pool?

Today, an awful lot of crypto assets are flowing into liquidity pools which arrived as an alternative to the traditional markets with buyers, sellers, and order book. Running on the AMM model, liquidity pools have proved to be a secure and efficient income source. What is a liquidity pool? How does a liquidity pool work? What are the top liquidity pools? Let’s go through the nuts and bolts! 

What Is a Liquidity Pool?

A liquidity pool is a pool of tokens locked in a smart contract allowing you to trade crypto. Sorry to burst your bubble if you ever thought of liquidity pools being filled with water. 

As for the traditional exchanges, the trade is successful only when buyers or sellers agree on the price and the amount. These conditions often make the process complicated.

To put it simply, you have to set a price which others are ready to buy or sell at. Here, everything runs in a different way. Liquidity pools work according to the algorithm which allows you to sell or buy regardless of the price, day time and availability of appropriate buyers or sellers.

How Do Liquidity Pools Work?

On the DEX, there is no order book and no live market maker. Liquidity pools are run by the AMM algorithm, which stands for automated market maker. Let’s break it down further into a few insights. 

1. Crypto holders deposit their assets and create trading pairs making them available for traders. 

2. Liquidity providers earn commission on their deposit which is a part of trading fees. Usually, commissions are based on the percentage of the amount of liquidity they have provided.

3. Traders pay trading fees for swapping crypto assets deposited by liquidity providers. 

4. Liquidity pools enhance trading by offering incentives to liquidity providers for depositing their funds.

5. There is no need for any third-party intermediary. The more crypto assets are placed in a liquidity pool, the better liquidity and trading experience this pool can offer.

What are Automated Market Makers? 

In the earlier days, DEXs ran the same model as centralized exchanges to facilitate trades. This model proved to be insufficient and ineffective, that’s why, later on, decentralized exchanges switched to the Automated Market Maker model (AMM).

Automated market makers make instant swaps possible by eliminating the gap between buyers and sellers; you don’t have to look and wait for preferable price conditions. Everything is run by the algorithm including setting up the price and matching buyers and sellers. In return, automated market makers charge a small fee for each trade. 

Using Liquidity Pools in 2022

Today, the crypto space is bubbled with multiple decentralized exchanges running on different blockchains, with the vast majority coming from Ethereum.

Nonetheless, more new DEXs are launching on Binance Smart Chain, Solana, Polygon, and others. 

Once again, a liquidity pool is a pool of tokens locked in a smart contract allowing you to trade crypto. Liquidity pools work according to the algorithm which allows you to sell or buy regardless of the price, day time and availability of appropriate buyers or sellers.