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What are Liquidity Pools, and How Do They Work? 

UTC by Osaemezu Ogwu · 6 min read
What are Liquidity Pools, and How Do They Work? 
Photo: Depositphotos

Decentralized finance has been at the center of the cryptocurrency blaze recently, and the liquidity pool is an essential aspect of DeFi. In this article, we’ll be describing the concept of liquidity pools, explain why we need them and how they work.

Liquidity pools refer to a pool of tokens locked in a smart contract. These tokens are used to initiate cryptocurrency trading by liquidating them. Liquidity pools are broadly relied upon by many decentralized exchanges to increase user participation and facilitate trade. Bancor introduced liquidity pools, but it became widely known when Uniswap adopted it. A liquidity pool is an automated market maker that provides liquidity to prevent huge asset price swings.

The fact that liquidity pool is essential to DeFi has been established, but why does Decentralized Finance technology need liquidity pools in the first place?

Why Do We Need Liquidity Pools?

Many commonly-used cryptocurrency exchange platforms utilize the order book model, which is similar to that used by traditional exchanges like NYSE. In this model, buyers and sellers are required to come together to place and take orders. Naturally, buyers will only make bids for crypto assets coming at the lowest price, and sellers, on the other hand, will only accept bids that come at the highest price. Problems may occur when no party is willing to place their orders at a fair price level. This makes trading difficult because it takes both parties to reach an agreement before a trade can be made.

This trading model’s major disadvantage is when both parties do not agree on a fair price; the trade is at risk of being off. Another disadvantage is the scenario where there is a shortage of coins, making it difficult to leave the market to the forces of demand and supply. To salvage any of these situations, the market makers are introduced to facilitate trade between parties.

Market makers are entities willing to buy or sell assets at a particular time. These market makers are liquidity providers to both buyers and sellers, and they rely on liquidity pools to make coins available. This means that traders do not necessarily have to wait for the other party before they trade. They can trade directly with these market makers.

The order book model is an applicable option for DeFi systems, but a major drawback is that it will be slow, expensive, and stressful for traders. The reality is that market makers tend to hike prices and cancel orders made by users on the exchange, which is not a fair market policy. Also, some cryptocurrencies are not ideal for adopting this model. For example, in Ethereum, the gas fee charged for interacting with the smart contract delayed transactions, and numerous trade requests make it difficult for users to update their orders.

Liquidity pools were introduced to combat these underlying issues with the order book model. Liquidity pools are an upgrade to the order book model, and it is entirely decentralized. They make transactions in the crypto market faster, more secure, and create a better user experience for traders. Having understood the need for liquidity pools in decentralized finance, let us examine how liquidity pools work.

How Do They Work?

A liquidity pool comprises of tokens, and each pool is used to create a market for the tokens that make up the pool. For example, a liquidity pool can contain ETH and an ERC-20 token like USDT, both of which will be available on the exchange. For every pool created, the first provider provides the initial price of available assets in the pool. This initial liquidity provider sets an equal value of both tokens to the pool.

In the example above, ETH sets the price of assets in the pool and provides an equal value of both ETH and USDT on a DeFi platform like Uniswap. Every liquidity provider that is interested in adding to the pool subsequently maintains the initial ratio set for the supply of tokens to the pool. For every time liquidity is provided to the pool, the provider gets a unique token called the liquidity pool token. It depends on how much liquidity the supplier has in the pool. All liquidity pool token holders are entitled to get a 0.3% fee distributed depending on the amount of input. To get back hidden tokens and each rate earned off partaking in the pool, the requesting provider is required to burn their liquidity tokens.

Price adjustment of liquidity pools in DeFi is determined by a mechanism known as the Automated Market Maker (AMM). Many known liquidity pools use a constant algorithm to keep the product of token quantities for both tokens. This algorithm enables the price of tokens in the pool to increase as token quantity increases.

The ratio of tokens in it determines the value of tokens in every liquidity pool. The size of the trade-in proportional to the size of the pool also determines the value of tokens. A large pool and less trade mean that the cost of tokens will decrease. Small pools and bigger trades equal a high cost of tokens.

DeFi platforms are now looking for innovative ways to increase liquidity pools because larger liquidity pools greatly reduce slippage and enhance their users’ trading experience. Protocols like Balancer reward liquidity providers with extra tokens for supplying liquidity to specific pools. This process is referred to as liquidity mining.

The introduction of Liquidity pools to decentralized finance (DeFi) is a big plus as it eliminates the problem of traders having to wait for market makers before they can trade. Liquidity pools and AMM are pretty straightforward and are an improvement on the centralized order book method used in traditional finance. There’s a plethora of liquidity pools that decentralized exchanges can choose from to make trading easier, faster, and better for their users.

Conclusion

Liquidity pools play an integral role in the DeFi ecosystem, and the concept has been able to make DeFi more decentralized. Liquidity pools make DeFi easier to use for both traders and the exchanges. To participate in liquidity pools, a user does not have to meet any special eligibility criteria or fill any KYC forms, which means that anyone can participate in providing liquidity for a token pair.

Centralization has been one of the primary concerns that blockchain and cryptocurrencies have set out to address. However, some centralized exchanges have had to rely on very few market-makers to provide liquidity for coins and tokens for a long time. Liquidity pools have been able to proffer solutions to the issue of centralization. Liquidity providers can earn by participating in liquidity pools, and as a result, user participation is ever increasing. This will ultimately lead to more decentralization and can address the problem of market manipulation, which is one of the challenges associated with the transparency of the crypto markets.

The simple liquidity pool concept has provided a solution to a large, complex problem like centralization, which has been one of the major challenges for the crypto space.

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