What are Liquidity Pools? Here’s All You Need To Know

In simple terms, liquidity pools are a collection of tokens or digital assets stored in a smart contract.

Liquidity in cryptocurrency refers to the ease with which you can convert your cryptocurrency into fiat currency or another asset without affecting its price.

Users can buy and sell cryptocurrency on decentralised exchanges and other DeFi platforms using liquidity pools instead of centralised market makers.

What Are Liquidity Pools?

A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens that are locked in a smart contract and are used to enable trades between assets on a decentralised exchange (DEX).

Liquidity pools are the primary technology behind the current DeFi ecosystem. Yield farming, lend-borrow protocols, automated market makers (AMM), designed resources, on-chain protection, blockchain games, etc. all depend on liquidity pools.

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Why Liquidity Pools Are Required?

Users can pool their assets in a DEX’s smart contracts to create liquidity pools, which offer asset liquidity for traders to trade across currencies. The DeFi ecosystem benefits from liquidity pools, which provide it with the liquidity, speed, and convenience it requires.

Automated Market Makers (AMM):

AMM enables on-chain trading without the need for an order book. You can think of an order book as a system where buyers and sellers are connected by the order book and willing to buy or sell assets to or from each other.

In AMM, traders can get in and out of positions on token pairs, which would likely be highly illiquid on order book exchanges as no direct counterparty is needed to execute trades.

When you’re executing a trade on an AMM, you don’t need to have a counterparty in the traditional sense. Essentially, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment; there only needs to be sufficient liquidity in the pool.

Yield Farming:

Liquidity pools are the basis of yield farming (or liquidity mining), where users add their funds to pools that are subsequently used to generate yield.

For crypto projects, distributing new tokens in the hands of the right people is a very difficult problem. One effective method for doing this has been yield farming, in which the tokens are distributed algorithmically to users that deposit their tokens in a liquidity pool.

The newly minted tokens are distributed proportionally to each user’s share of the pool.

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