What's that Liquidity Pool?

In the decentralized finance (DeFi) ecosystem there is a central element called liquidity pool. This innovation facilitates smooth and efficient trading. Understand more about liquidity pools in this article.

What is a Liquidity Pool?

Liquidity pools are dynamic reservoirs of tokens locked in smart contracts, strategically designed to inject liquidity into decentralized exchanges. This mechanism aims to mitigate the challenges faced by the inherent illiquidity of decentralized systems.

Liquidity pool also refers to the gathering of orders that determine price levels. When this level is reached, the asset faces an important decision—whether to continue moving up or down.

Decentralized exchanges that utilize the power of liquidity pools generally use automated market maker (AMM) based systems. This trading platform abandons conventional order books, opting to rely on pre-funded on-chain liquidity pools to support both assets in a trading pair.

Benefits of Liquidity Pools

Utilizing a liquidity pool eliminates the need for buyers and sellers to simultaneously agree to exchange two assets at a certain price. Instead, it relies on pre-funded liquidity pools, facilitating trading with minimal slippage for even the most illiquid trading pairs—provided there is a large enough liquidity pool.

Funds in the liquidity pool are contributed by users who want to earn passive income through trading fees. The fees earned are directly related to the percentage of liquidity pool provided by each user.

How Liquidity Pools Operate

Reservoir Token:

The liquidity pool functions as a reservoir, containing tokens secured in smart contracts. This token plays a key role in maintaining liquidity on decentralized exchanges.

Automated Market Maker (AMM):

Decentralized exchanges that utilize liquidity pools operate on AMM-based systems, replacing conventional order books with on-chain liquidity pools.

Slippage Reduction:

Liquidity pools effectively reduce slippage concerns, enabling smooth trading even in less liquid trading pairs, depending on the size of the liquidity pool.

Passive Income for Contributors:

Users who contribute funds to a liquidity pool become liquidity providers, earning passive income through trading fees. The fees earned are directly related to the percentage of liquidity pool provided by each user.

Liquidity Pool Evolution

The liquidity pool concept was first introduced by the Ethereum-based trading system, Bancor. However, it gained widespread adoption in the crypto space after its influential endorsement by Uniswap.

Conclusion

Liquidity pools are at the forefront of infusing liquidity into decentralized exchanges. Through the strategic use of smart contracts and pre-funded liquidity pools, this mechanism offers a solution to the challenge of inherent illiquidity, fostering a more dynamic and efficient trading environment within a decentralized landscape.

As the crypto space evolves, liquidity pools remain a cornerstone, allowing users to actively participate in decentralized exchanges while contributing to the liquidity reservoir.

Read also:

Apa Itu Curve Finance (CRV)? Automated Market Maker Protocol

What is Slippage?

What is an Automated Market Maker (AMM) in Crypto Trading

DISCLAIMER: This article is informational in nature and is not an offer or invitation to sell or buy any crypto assets. Trading crypto assets is a high-risk activity. Crypto asset prices are volatile, where prices can change significantly from time to time and Bittime is not responsible for changes in fluctuations in crypto asset exchange rates