What is a liquidity pool? How do liquidity pools work? (2022)

What is a liquidity pool?

Liquidity pool is a basically pool of crypto tokens that are put together and kept securely within a smart contract to enable decentralized trading. They exist mostly in AMM DEXes (decentralized exchanges); however, afterwards, they have also been utilized by other decentralized applications like lending & borrowing products.

The majority of liquidity pools consist of a pair of cryptocurrencies, which directly allows the trading between the two. Nevertheless, later decentralized exchanges like Balancer have proved that liquidity pools are not necessarily made up of only a pair of cryptocurrencies: with their innovation, up to 8 tokens can be flexibly added and traded within one single liquidity pool.

Liquidity pools are first defined and used in AMM DEXes, started with Bancor and popularized by Uniswap. Liquidity pools enable the use of AMM (Automated Market Maker) that facilitates decentralized trading with numerous benefits compared to the traditional approach.

How do liquidity pools work?

Before going into how liquidity pools work, first, let’s take a look at how the original trading method: via order books.

Order books consist mainly of 2 participants: makers and takers

• Makers: The ones who make the order.
• Takers: The ones who take the order.

Order books work similarly to negotiations: Makers put up an affordable price for their buy/sell orders, and takers are willing to pay such a price for those orders.

The avenue of order books itself is flawed: it is difficult to complete an order. There are multiple reasons behind this, namely makers and takers cannot agree on a mutual price, or there are not enough available assets for sale (lack of liquidity).

Therefore, order books almost always involve market makers - third parties that are always willing to make buy/sell orders at certain prices for others to take. In other words, they provide liquidity to a market.

This imposes a few problems, with the biggest of them being centralized, meaning it cannot work in DeFi. To enable decentralized trading, another approach is necessary. This is when liquidity pools come into place.

AMM automates the trading process by eliminating the involvement of market makers. For AMM to work, liquidity pool is the core factor.

Instead of market makers, AMM incentivizes users to become liquidity providers. This can be anyone, including the traders themselves. Liquidity providers offer liquidity to a liquidity pool, in return, receive trading fees and earn farming rewards.

As mentioned above, liquidity pools are usually pools that contain a pair of tokens. Liquidity providers add liquidity by depositing both at a pre-defined ratio. The ratio will be based on the price correlation between those 2 tokens.

For example, 1 ETH equals 2,000 USDC. To provide liquidity to this liquidity pool of ETH-USDC, one has to deposit both ETH and USDC with an ETH-USDC ratio of 1:2,000. As the price of ETH changes, the ratio of the two tokens in the pool will be adjusted accordingly.

Pros and cons of liquidity pool

Liquidity pool is a ground-breaking innovation in the DeFi space. Even though it has brought tremendous evolutionary changes to crypto, it is still much flawed and requires improvements.

Pros

• Enable decentralized trading, eliminating the involvement of third parties.
• Facilitate liquid markets without much cost and time.
• Offer numerous financial applications to earn profits.

Cons

• Can cause slippage/price impact if the liquidity pool is small.
• Ease of access and creation paves the way for fraudulent projects to take advantage with low risk and cost.
• Liquidity providers can receive enormous losses while farming rewards due to impermanent loss (IL).
• Incentives for liquidity providers are still unsustainable, making liquidity difficult to scale.

How to become a liquidity provider

You can become a liquidity provider at any AMM DEX on the market. I’ll take SushiSwap as an example. 

First, go to their website here and connect to your wallet.

Point to “Liquidity” and click on “Add”.

Here you can select the pair of tokens that you want to provide liquidity to, approve them to be used by SushiSwap then add liquidity.

Learn more: How to use SushiSwap

Why are liquidity pools important?

Liquidity pools are important because they are the core component of any AMM DEX. Liquidity is the blood of any market, and liquidity pools are the ones that supply such liquidity. Without liquidity pools, AMM DEXes cannot operate, and DeFi, in general, becomes unusable.

FAQs about liquidity pool

Are liquidity pools safe?

The safety of liquidity pools depends on the smart contract behind them. As mentioned above, liquidity pools are pools of crypto tokens that are put together and kept securely within a smart contract.

Smart contracts can include insecure functions that are beneficial to crypto scammers since they can withdraw all of the liquidity within those pools to their possession. Before interacting or using any liquidity pool, ensure that the product you are using is secure and safe, with their smart contracts fully audited.

You can use this website to check the security of a smart contract.

How to create a liquidity pool

You can create a liquidity pool on any permissionless AMM DEX, like Uniswap or SushiSwap. The process is similar to adding liquidity, as guided above. Creating a liquidity pool means you are providing liquidity to a token pair that does not have a liquidity pool yet.

Simply choose the token pair you want to create a liquidity pool, and add liquidity to that pair. If a token is not yet available on that DEX, add the token manually by pasting its address into the search bar.

Yield Farming vs. Liquidity Pool

As mentioned earlier, yield farming is an incentive that the AMM DEX creates to incentivize liquidity provision. If you provide liquidity to a liquidity pool, you will not only receive a portion of the pool’s trading fees but also obtain permission to yield farm and earn additional rewards.

Conclusion

Liquidity pools are basically pools of crypto tokens that are put together and kept securely within a smart contract to enable decentralized trading. They exist mostly in AMM DEXes (Decentralized Exchanges); however, afterwards, they have also been utilized by other decentralized applications like lending & borrowing products.

Liquidity pool is a ground-breaking innovation in the DeFi space. Even though it has brought tremendous evolutionary changes to crypto, it is still much flawed and requires improvements.