What Is a Liquidity Pool?

A liquidity pool is a pool of tokens locked in a smart contract allowing you to trade crypto. Sorry to burst your bubble if you ever thought of liquidity pools being filled with water. As for the traditional exchanges, the trade is successful only when buyers or sellers agree on the price and the amount.

How Do Liquidity Pools Work?

Liquidity pools are run by the AMM algorithm, which stands for automated market maker. Liquidity providers earn commission on their deposit which is a part of trading fees. Usually, commissions are based on the percentage of the amount of liquidity they have provided. Traders pay trading fees for swapping crypto assets deposited by liquidity providers.

Liquidity pools enhance trading by offering incentives to liquidity providers for depositing their funds.

What are Automated Market Makers?

This model proved to be insufficient and ineffective, that’s why, later on, decentralized exchanges switched to the Automated Market Maker model . Everything is run by the algorithm including setting up the price and matching buyers and sellers. In return, automated market makers charge a small fee for each trade.

Using Liquidity Pools in 2022

A liquidity pool is a supply of cryptocurrencies or tokens locked in a smart contract in order to keep a decentralized exchange liquid for trades to be executed. Liquidity pools allow users to pool their assets in a DEX’s smart contract to provide liquidity for traders to swap between currencies. Liquidity pools facilitate speed, and convenience to the DeFi ecosystem like decentralized trading, lending, borrowing and other DeFi activities. Liquidity pools are the foundation of many decentralized exchanges , such as Uniswap and Pancakeswap.

Those who provide assets are called liquidity providers . AMMs solve this problem of insufficient liquidity by creating liquidity pools and enabling liquidity providers to supply these pools with assets without a 3rd party.