What is a Liquidity Pool?

A liquidity pool is a smart contract that contains a reserve of two or more cryptocurrency tokens on a decentralized exchange (DEX). Liquidity pools encourage investors to earn passive income with cryptocurrencies that would otherwise be unused.The exact process for joining a liquidity pool can vary depending on the platform, but it typically involves setting up an account on a decentralized finance (DeFi) platform, connecting an Ethereum wallet to the account, and depositing two different types of tokens into the platform’s pool to form a trading pair. (Most liquidity pools require cryptocurrencies to be deposited in equal value pairs).

What Liquidity Pools Accomplish

Liquidity pools allow buyers and sellers of cryptocurrencies to trade tokens on a DEX without the need for a centralized order book or a traditional market maker. Instead, all trading activity is facilitated by the smart contract that governs the pool.Automated market maker (AMM) algorithms within the contract determine the price of each token and adjust prices in real-time based on supply and demand. This ensures that the supply of each token in a pool is always proportional to the other tokens in the pool.Investors who add their tokens to the pool receive a share of the exchange’s trading fees or another investment incentive. The value of the incentive received is proportional to the liquidity provided by the investor.

History of Liquidity Pools

In the early days of DeFi, decentralized exchanges used traditional bank order books to match buyers and sellers. This approach was problematic for several reasons:

• The order books required a significant amount of computing power to match buyers and sellers, and the process was slow.
• High gas fees made it difficult for smaller traders to participate in the market.
• Traditional order books are susceptible to front-running, where users with faster connections could see and execute fills before users with slower connections.

In 2017, the co-founders of Bancor Network found a way to address these issues by executing trades against the liquidity of a crowdsourced pool of assets. This single change is credited with driving the rapid growth of DeFi.

The Importance of Liquidity Pools

Liquidity pools play a crucial role in blockchain protocols for lending, yield farming, on-chain insurance, and gaming protocols.In traditional finance, also known as centralized finance (CeFi), a buyer must be matched with a seller before a transaction can be completed. In contrast, DeFi platforms can automatically execute a trade against the liquidity in the platform’s pool.This is important because DeFi platforms don’t have to match the expected price of a trade with the executed price. If the executed price of the trade is higher than the expected price, the buyer simply receives fewer tokens than expected, and the seller receives more tokens. This is known as slippage.To compensate for potential losses due to slippage, the pool charges a small fee for each transaction and distributes the fee among the liquidity providers in proportion to their share of the pool.

Total Value Locked

DeFi liquidity is typically expressed in the form of Total Value Locked (TVL). TVL represents the total value of assets locked in a particular DeFi platform. This typically includes the amount of cryptocurrency locked in smart contracts, as well as any other assets the platform has tokenized.TVL is an important metric for DeFi protocols as it gives investors an indication of the overall liquidity of a platform. Platforms with a higher TVL generally have greater growth potential than platforms with a lower TVL.