Liquidity Pool Meaning
What is a Liquidity Pool?
Liquidity describes the ease at which an individual can convert a digital asset into fiat money or other digital assets without causing drastic price swings. Centralized exchanges depend on market makers and order books to maintain liquidity. In contrast, most decentralized finance (DeFi) platforms rely on liquidity pool to operate.
A liquidity pool is a collection of assets in a big digital pile that facilitates automated and permissionless transactions on DeFi platforms. The funds are locked in pieces of self-executing codes called smart contracts. DeFi ecosystems that utilize liquidity pools include decentralized exchanges (DEXs), yield farms, and crypto lending platforms, among others.
Liquidity pools serve the same purpose as market makers – which is to provide market liquidity and depth to ensure users make faster transactions and at fair prices. They replaced traditional order books that relied on buyers and sellers to determine the price for exchanging two assets.
How Do Liquidity Pools Work?
DeXs incentivizes users for providing liquidity to eliminate illiquid market issues, such as slippage. Hence, having more digital assets in a pool shows a platform’s stability and capacity to offer better liquidity. The users pooling their digital assets into liquidity pools are known as liquidity providers (LPs). LPs add an equal value of trading pairs into the pool and earn a fraction of trading fees or crypto rewards.
A DEX requires that a liquidity pool has more than one token to facilitate buying and selling or swapping between two tokens or trading pairs. For instance, when you purchase token X with token Y on a DEX, the supply of token Y in the pool increases while that of X reduces. In return, the price of token Y drops and that of X rises. This means that a token’s availability can influence its price.
To ensure that the pool is constantly liquid, DeFi platforms use different pool pricing algorithms, also known as automated market makers (AMMs), to automatically adjust pricing. Executing trades on AMMs is typically peer-to-contract based as you are trading against the liquidity in the pool rather than a counterparty.
Liquidity pools can also be used for governance, where users pool together their funds to vote for a common cause regarding a protocol’s governance proposals. Another instance is liquidity mining or yield farming, where users provide liquidity to a DEX to generate yield as freshly minted tokens. They are also essential for blockchain-based gaming, on-chain insurance against smart contract risks, and collateralizing minting synthetic assets.