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What are liquidity pools and how do they work?



Liquidity pools, in simple terms, are a group of tokens locked into a smart contract. They enable decentralized lending (lending), trading (trading) and other functions by providing liquidity. Liquidity refers to the ease with which a currency can be converted into cash or other currencies.


Liquidity pools are an essential part of the DeFi ecosystem. They provide the basis for many decentralized exchanges (DEX) such as 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 activity. One of the main technologies behind the ecosystem is the liquidity pool.


A liquidity pool is a crowdsourced pool of tokens locked into a smart contract. They are used to facilitate exchanges on a decentralized exchange. Instead of traditional buyer and seller marketplaces, many DeFi platforms use automated market makers (AMMs) to enable automated, permissionless exchanges of digital assets through liquidity pools.


In exchange for providing liquidity, the liquidity provider (LP) is rewarded with special LP tokens in proportion to the liquidity provided. When a pool facilitates an exchange, a trading fee is distributed among all LP token holders in proportion to their share of total liquidity.


Why are they necessary?

Centralized exchanges (CEX) such as Coinbase and Binance and traditional exchanges use the order book trading model. In this model, in order to complete a trade, the buyer and seller must converge on price. Market makers facilitate trading by providing liquidity, as they are always willing to buy or sell a certain asset.


However, DeFi trading must be performed on-chain, without a centralized intermediary. Since every interaction with the order book comes with a gas fee, it is much more expensive to complete trades. Blockchains also can't handle the scale required to trade billions of dollars every day.


Thus, it is nearly impossible for a blockchain like Ethereum to operate on an on-chain order book exchange. (However, there are some DEXs that work with order books).


How do they work?

Automated Market Makers (AMMs) allow on-chain trading without the need for a direct counterpart to complete trades. So, as long as there is enough liquidity in the pool, the buyer can buy, even if there is no seller present at that particular time.


What are they for?

We have already discussed AMMs as one of the primary uses of liquidity pools. However, they are also used in a number of other ways such as yield farming or liquidity mining. Liquidity pools are the basis of platforms like Yield, where participants deposit funds into pools that are used to generate returns.


Risks

Like most things, liquidity pools are not without risk. It is important to be aware of risks such as 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 the deposited assets changes from when they were deposited.


Examples of liquidity pools:


Popular exchanges that use liquidity pools include SushiSwap, UniSwap, and PancakeSwap.



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