Liquidity pools can be complex and nuanced, but we’re going to touch on high-level concepts to help you learn more about them and what they provide to the cryptosphere.
Liquidity pools essentially are a collection of tokens locked up in a smart contract that provide liquidity to decentralized exchanges. Liquidity is a vital aspect of any exchange (e.g. crypto & equity markets). It is the mechanism by which trades are executed quickly and efficiently without causing wild volatility and price-swings. If an asset is not liquid, it would take a long time to execute a trade. You could also run into slippage, which is the difference in the price you wanted to sell an asset for vs. the price it actually sold for. DeFi relies on liquidity pools to work properly. Without liquidity, decentralized exchanges would crumble. When DEXs were a new concept, the number of buyers and sellers was small, which made finding buyers and sellers to execute trades difficult.
In the traditional order book method, buyers and sellers submit orders for the number of tokens they want to trade and at what price. This means that someone else must be willing to meet an order for it to execute. Liquidity pools don’t rely on the order book method. They allow buy and sell orders to be executed no matter the price without looking for a direct buyer or seller. The system uses an Automated Market Maker (AMM) to enable this.
AMMs provide a solution by creating liquidity pools and offering providers of the liquidity (liquidity providers — LPs) incentives to supply these pools with crypto for trading pairs (e.g. BTC-USDT). They help eliminate the need for the middleman (centralized entity). The more crypto in a liquidity pool, the more liquidity the pool has. The more liquidity the pool has, the more efficient trading becomes.
AMMs are an essential part of liquidity pools. An AMM is a protocol that enables digital assets to trade in an automated fashion instead of with traditional buyers and sellers. The fair-market-price of the tokens in the pool is determined by an algorithm of the AMM itself.
Liquidity pools are designed to incentivize LPs to stake their assets in a pool and earn trading fees and rewards for doing so. An LP receives rewards depending on the amount of liquidity they have provided the pool with.
Liquidity pools may have been born from necessity, but their innovation brings a fresh new way to provide decentralized liquidity algorithmically through incentivized, user funded pools of asset pairs.