Liquidity Pool
What is a liquidity pool?
Liquidity pools are a collection of tokens or digital assets locked in a smart contract that provide essential liquidity to decentralized exchanges.
Liquidity pools play a large part in creating a liquid decentralized finance (DeFi) system.
In traditional finance, liquidity is provided by buyers and sellers of an asset. In contrast, DeFi relies on liquidity pools to function. A decentralized exchange (DEX) without liquidity is equivalent to a plant without water –– it won’t survive. Liquidity pools provide a lifeline to DEXs.
A liquidity pool is a collection of cryptocurrency that's locked in a smart contract. This results in creating liquidity for faster transactions.
A major component of liquidity pools are automated market makers (AMMs). An AMM is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.
In other words, users of an AMM platform supply liquidity pools with tokens, and the price of the tokens in the pool is determined by a mathematical formula of the AMM itself.
Liquidity pools are also essential for yield farming and blockchain-based online games.
Liquidity pools are designed to incentivize users of different crypto platforms, called 'liquidity providers' (LPs). After a certain amount of time, LPs are rewarded with a fraction of fees and incentives, equivalent to the amount of liquidity they supplied, called liquidity provider tokens (LPTs). LP tokens can then be used in different ways on a DeFi network.
Let's compare a liquidity pool to a centralized exchange. A centralized exchange provides liquidity itself for its users to trade on the platform. For providing its service, the centralized exchange collects fees from transactions.
A decentralized exchange, on the other hand, has no team or centralized entitiy to provide liquidity, so instead, the DEX allows anyone within the crypto ecosystem to provide their own liquidity on the platform. When transactions take place on the DEX, fees are still collected, however, the earnings are distributed to the liquidity providers rather than a centralized company.
SushiSwap (SUSHI) and Uniswap are common DeFi exchanges that use liquidity pools on the Ethereum network containing ERC-20 tokens. At the same time, PancakeSwap uses BEP-20 tokens on the BNB Chain.
What is the purpose of a liquidity pool?
In a trade, traders or investors can encounter a difference between the expected price and the executed price. That is common in both traditional and crypto markets. The liquidity pool aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.
Trades with liquidity pool programs like Uniswap don't require matching the expected price and the executed price. AMMs, which are programmed to facilitate trades efficiently by eliminating the gap between the buyers and sellers of crypto tokens, make trades on DEX markets easy and reliable.
Pros and cons of liquidity pools
Pros:
Simplifies DEX trading by performing transactions at real-time market prices.
Allows people to provide liquidity and receive rewards, interest or an annual percentage yield on their crypto.
Uses publicly viewable smart contracts to keep security audit information transparent.
Cons:
Risk of hacking exploits because of poor security protocols, causing losses for liquidity providers.
Risk of frauds such as rug pulls and exit scams.
Exposure to impermanent loss. This happens when the price of your assets locked up in a liquidity pool changes and creates an unrealized loss, versus if you had simply held the assets in your wallet.
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