Liquidity pools are one of the key elements of the decentralized space, and automated market makers, yield farming, borrow-lend protocols, and even blockchain gaming all make use of them. With centralized exchanges rising in volume and facilitating more than 95% of cryptocurrency transactions, Decentralized exchanges had to step up to compete; this is the reasoning behind the advent of one of DeFi’s core products, the liquidity pool.
A liquidity pool is a set of digital assets that are locked in smart contracts to facilitate trading and lending on decentralized exchanges. Liquidity pools are the rock of many DEXs, such as Pancakeswap and Uniswap. These pools provides liquidity to DEXs and creates price levels that are not dependent on market forces; they also contain ERC-20 tokens.
The Difference Between a Liquidity Pool and Order Books
To better understand what liquidity pools are, you need to fathom how CEXs are able to match trading orders. CEXs do this through order books. The order book is a collection of the recent open orders for a given market, which functions alongside the matching engine—a system that matches orders and is at the core of centralized exchanges. This model facilitates effective exchange and allows for the creation of financial markets; however, this poses a problem. DeFi trading entails executing on-chain trades without a centralized party to hold the funds. This makes interaction with the order book expensive and more complicated to execute trades.
How Liquidity Pools Work
Liquidity pools have changed the way on-chain trades are executed as you no longer need order books to determine orders. Since there is no direct counterpart, traders can get in and out of trading positions on pairs that would have been illiquid on order books. In summary, order books connect buyers and sellers but only facilitate the trading of popular digital currency pairs, while liquidity pools connect buyers with a contract. When executing a trade on an AMM, you are executing the trade against the liquidity pool, so buyers do not buy from sellers at that moment. Pricing is determined by an algorithm based on the trades happening in the pool.
Benefits of Liquidity Pools
The main benefit of the liquidity pools is that it does not require the buyers or sellers to decide the market prices of a given pair. Once funded, the pool allows for trades to occur at any time with limited slippage, even for the most illiquid pair, providing the liquidity pool is large enough. The funds locked in the liquidity pool are provided by users who are also known as liquidity providers. These people could be crypto enthusiasts, traders, or investors. They add an equal value of two tokens in the pool to form a market, and they earn passive income on their liquid deposits in exchange through trading fees that are in accordance with the percentage offered by the protocol. Sometimes, these protocols give out tokens as rewards, which can be traded on DEXs and CEXs.