What Is A Liquidity Pool?
In itself, the idea is profoundly simple. A liquidity pool is basically funds thrown together in a big digital pile. But what can you do with this pile in a permissionless environment, where anyone can add liquidity to it?
Introduction
But what makes all this expansion possible? One of the core technologies behind all these products is the liquidity pool.
What is a liquidity pool?
A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and many more functions we’ll explore later.
As anyone can be a liquidity provider, AMMs have made market making more accessible.
Liquidity pools vs. order books
To understand how liquidity pools are different, let’s look at the fundamental building block of electronic trading – the order book. Simply put, the order book is a collection of the currently open orders for a given market.
How do liquidity pools work?
Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without the need for an order book. As no direct counterparty is needed to execute trades, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges.
As we’ve mentioned, a liquidity pool is a bunch of funds deposited into a smart contract by liquidity providers. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool.
Of course, the liquidity has to come somewhere, and anyone can be a liquidity provider, so they could be viewed as your counterparty in some sense. But, it’s not the same as in the case of the order book model, as you’re interacting with the contract that governs the pool.
What are liquidity pools used for?
So far, we’ve mostly discussed AMMs, which have been the most popular use of liquidity pools. However, as we’ve said, pooling liquidity is a profoundly simple concept, so it can be used in a number of different ways.
Distributing new tokens in the hands of the right people is a very difficult problem for crypto projects. Liquidity mining has been one of the more successful approaches. Basically, the tokens are distributed algorithmically to users who put their tokens into a liquidity pool. Then, the newly minted tokens are distributed proportionally to each user’s share of the pool.
We could also think about governance as a use case. In some cases, there’s a very high threshold of token votes needed to be able to put forward a formal governance proposal. If the funds are pooled together instead, participants can rally behind a common cause they deem important for the protocol.
Another emerging DeFi sector is insurance against smart contract risk. Many of its implementations are also powered by liquidity pools.
What else can we think of? There are probably many more uses for liquidity pools that are yet to be uncovered, and it’s all up to the ingenuity of DeFi developers.
The risks of liquidity pools
Closing thoughts
Liquidity pools are one of the core technologies behind the current DeFi technology stack. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power almost every part of DeFi, and they will most likely continue to do so.
