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Liquidity pools enable users to buy and sell crypto on decentralized exchanges without the need for centralized market makers.

Liquidity Pools

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A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract temuland crypto glossary smart contract Smart contracts are simply programs stored on a blockchain that run when predetermined conditions are met.Learn more that is used to facilitate trades between the assets on a  decentralized exchange (DEX) A decentralized exchange (DEX) is a type of cryptocurrency exchange that allows peer-to-peer transactions without the need for an intermediary. A decentralized exchange is a type of cryptocurrency exchange that allows peer-to-peer transactions without the need for an intermediary.Learn more. Instead of traditional markets of buyers and sellers, many decentralized finance (DeFi) platforms use automated market makers (AMMs), which allow digital assets to be traded in an automatic and permissionless manner through the use of liquidity pools.

Liquidity pools provide much-needed liquidity, speed, and convenience to the DeFi ecosystem.

Before automated market makers (AMMs) An automated market maker (AMM) is the underlying protocol that powers all decentralized exchanges (DEXs). Automated market makers (AMM) are methods that automate digital asset trading without the need for authorizationLearn more came into play, crypto market liquidity was a challenge for DEXs on EthereumEthereum2$ 1,295.800.88%-1.91%0.19%details. At that time, DEXs were a new technology with a complicated interface and the number of buyers and sellers was small, so it was difficult to find enough people willing to trade on a regular basis. AMMs fix this problem of limited liquidity by creating liquidity pools and offering liquidity providers the incentive to supply these pools with assets, all without the need for third-party middlemen. The more assets in a pool and the more liquidity the pool has, the easier trading becomes on decentralized exchanges.

Liquidity pools are the backbone of many decentralized exchanges (DEX), such as Uniswap. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.

As anyone can be a liquidity provider, AMMs have made market making more accessible.

To understand how liquidity pools are different, let’s look at the fundamental building block of electronic trading – the order book. Simply put, the order book is a collection of the currently open orders for a given market.

The system that matches orders with each other is called the matching engine. Along with the matching engine, the order book is the core of any centralized exchange (CEX). This model is great for facilitating efficient exchange and allowed the creation of complex financial markets.
DeFi trading, however, involves executing trades on-chain, without a centralized party holding the funds. This presents a problem when it comes to order books. Each interaction with the order book requires gas fees, which makes it much more expensive to execute trades.

Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without the need for an order book. As no direct counterparty is needed to execute trades, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges.

As we’ve mentioned, a liquidity pool is a bunch of funds deposited into a smart contract by liquidity providers. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, 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, only sufficient liquidity in the pool.

Pooling liquidity is a profoundly simple concept, so it can be used in a number of different ways.

One of these is yield farming or liquidity mining. Liquidity pools are the basis of automated yield-generating platforms like yearn, where users add their funds to pools that are then used to generate yield.

Distributing new tokens in the hands of the right people is a very difficult problem for crypto projects. Liquidity mining has been one of the more successful approaches. Basically, the tokens are distributed algorithmically to users who put their tokens into a liquidity pool. Then, the newly minted tokens are distributed proportionally to each user’s share of the pool.

We could also think about governance as a use case. In some cases, there’s a very high threshold of token votes needed to be able to put forward a formal governance proposal. If the funds are pooled together instead, participants can rally behind a common cause they deem important for the protocol.

Another emerging DeFi sector is insurance against smart contract risk. Many of its implementations are also powered by liquidity pools.

There are probably many more uses for liquidity pools that are yet to be uncovered, and it’s all up to the ingenuity of DeFi developers.

It's liquidity that moves markets.

Stanley Druckenmiller
American investor