What are liquidity pools?

Decentralized exchanges (dexs) are similar to traditional or centralized exchanges (cexs) in that they require a high level of liquidity to function efficiently. However, in the early days of DeFi, dexs suffered from a lack of liquidity. They did not have access to the same resources traditional markets did, such as order books that matched buyers with sellers at different price levels.

Now, liquidity pools offer a decentralized solution to this issue. In addition, liquidity pools have enabled the widespread growth of new DeFi products, such as crypto lending and borrowing, yield farming, on-chain insurance, and play-to-earn (P2E) gaming.

What is a liquidity pool?

Simply put, a liquidity pool is a vast collection of token pairs locked in a smart contract that allows for the trading and swapping of tokens on dexs. Users don’t require a counter-party when they execute trades, because trades go against the ‘pools’ of assets deposited in smart contracts (liquidity). Liquidity pools operate via crowd-sourcing, meaning any user can stake their tokens to a smart contract to provide liquidity for a DeFi platform and thus, participate in facilitating trades.

Liquidity pools are an intrinsic part of automated market makers (AMMs), which are the mechanisms that allow tokens to be traded automatically and in a permissionless manner. AMMs allow for on-chain trading without requiring an order book, which has been used traditionally to connect sellers and buyers.

You can think of AMMs as software code and liquidity pools as the tokens being moved around. AMMs solve DeFi’s liquidity problem by creating liquidity pools of various token pairs and incentivizing LPs. And importantly, this is done without third-party mediators.

Who are the liquidity providers?

Users who add liquidity to a liquidity pool by staking their tokens are called liquidity providers (LPs). Because of crypto’s permissionless nature, anyone can become an LP. LPs can fund the pools only with token pairs, creating different paired markets. For example, you can fund a pool with an equal amount of ETH and USDT to create more liquidity for this trading pair and therefore, help people trade with one another.

But why do users deposit their tokens using smart contracts? Liquidity pools incentivize LPs to deposit their own tokens into the pools, and they often do so by sharing trading fees and other token rewards in exchange for their token deposits.

Rewarding the LPs

Liquidity pools usually have their native token, generally called an LP token. Users who stake token pairs in a liquidity pool will receive LP tokens based on the amount they supply to the pool.

Each time a trade takes place in the pool, it distributes a part of the fees (depending on the pool’s rules) proportionally to LP token holders. Once an LP transfers their stake back, the system destroys their LP tokens to stabilize the reward mechanism, according to the new amount of LPs.

Liquidity pools are a prime example of DeFi’s automaticity — they solve the problem of illiquid markets by incentivizing users to provide liquidity in return for a portion of the trading fees. Some users hold tokens that enable them to earn rewards when they deposit those tokens to help facilitate different decentralized market functions seamlessly.

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