What are liquidity pools? They are a special feature in decentralized exchanges (DEX), which distinguishes them from other centralized markets. As suggested by its name, liquidity pools are digital assets thrown togETHer in a big digital pile. This pile is not governed by any centralized market makers, but rather, automated market makers (AMM), which we will discuss later.
Because of liquidity pools, decentralized finance (DeFi) has seen an unprecedented rise in activity. DEX volumes can match the volumes on centralized exchanges. So let us explore why liquidity pools are so important in DeFi and DEX.
What are liquidity pools?
A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools can facilitate decentralized trading and lending among many other functions.
Anyone can be a liquidity provider – users who contribute tokens to the liquidity pool. An equal value of two tokens are added to the pool to create a market. Liquidity providers can earn trading fees from the trades that happen in their pool.
Automated Market Makers (AMMs)
DEXs are different from traditional centralized exchanges because liquidity pools have automated market makers (AMMs) that help facilitate trading. In the case of centralized exchanges, the order book and the matching engine are what drives exchanges. Both the order book and the matching engine work togETHer to match any two particular traders who are willing to exchange assets.
While such a system is well-established, the presence of an order book gives rise to a problem in DeFi trading. This is because DeFi trading executes trades on-chain, with the absence of a centralized party holding the funds. This means that every interaction with order books will incur tremendous amounts of gas fees, making it very expensive to execute trades.
To solve this, DeFi has introduced AMM to greatly facilitate on-chain trading without causing an enormous amount of gas fees. While you can think of traditional trading as peer-to-peer, AMM trading is essentially peer-to-contract, where you are essentially trading against a liquidity pool. This is made possible through the use of smart contracts on the blockchain. This greatly facilitates liquidity as we do not have to find a seller on the other end of the transaction.
Why are liquidity pools important?
Any experienced trader in traditional or crypto markets would know that a market that is illiquid will bring about problems such as slippage. Slippage is the difference between the expected price of a trade and the price at which it is executed. This is most common during periods of higher volatility, and also during periods when the market does not have sufficient liquidity.
Liquidity pools target this issue at hand by ensuring that there is sufficient liquidity in the market. Users are incentivized as well to deposit some crypto funds to earn a share of the trading fees. When a pool facilitates a trade, a partial fee is proportionally distributed amongst the liquidity providers.
Other benefits
Users may use liquidity pools for yield farming or liquidity mining. For new projects, distributing new tokens in the hands of the right people is a difficult problem. Through an algorithm, newly minted tokens are distributed proportionally to the users who put their tokens in a liquidity pool.
In Conclusion
What are liquidity pools? They are an ingenious addition to the blockchain which solves problems of illiquidity. They enable decentralized trading, lending, yield generation and more. In fact, the potential is endless for such smart contracts as they can pave the way for greater improvements and additions in the future.
