Home CryptoNews What Are Liquidity Pools and How Do They Work?

What Are Liquidity Pools and How Do They Work?

Liquidity is an important aspect of not only traditional markets, but also the crypto market due to the highly volatile nature of cryptocurrencies. In simple words, liquidity is the availability of liquid assets to a market. The reason liquidity is so important is that it largely affects how the price of an asset will move.

DeFi market is booming and it would be very helpful to know about some concepts used in DeFi. In this article, we will explain what are Liquidity pools in DeFi and how they work.

What are Liquidity Pools?

In Decentralized Finance (DeFi), Liquidity pools are pools of tokens that are locked in a smart contract. They facilitate efficient trading of assets while allowing investors to earn a yield on their holdings. Behind the scenes, a liquidity pool is just an automated market maker that provides liquidity to prevent huge price swings of an asset.

But why DeFi needs liquidity pools in the first place? The answer is that the order-book model used by standard crypto exchanges like Coinbase and Binance is not a viable solution for DeFi. The reason is that the order-book model heavily relies on market makers. When there is no market maker, an exchange becomes instantly illiquid.

The order-book system model works well when there are enough buyers and sellers in the market. But when it is not, tokens that lack liquidity due to low volume or interest not only become difficult to buy and sell. These illiquid tokens can cause unpredictable price swings just by some large individual transactions. Therefore, tokens with high price volatility and inefficient conversions are unlikely to be adopted.

Decentralized liquidity pools address this by providing constant liquidity and also rewards liquidity providers for their contribution. So, how they work?

How do Liquidity Pools Work?

Liquidity pools use algorithms called Automated Market Makers (AMM) to provide constant liquidity for trading.

A single liquidity pool holds a pair of tokens and each pool creates a new market for that particular pair of tokens. The first depositor to the pool or liquidity provider sets the initial price of assets in the pool. Liquidity providers are incentivized to supply an equal value of both tokens to the pool. They receive special tokens called LP token in proportion to their contribution to the pool. When a trade occurs, a 0.3% fee is collected and distributed proportionally to all LP token holders.

When a token swap occurs through a pool, the supply of an asset decreases while of other increases. Therefore, price changes occur that are adjusted by an algorithm called an automated market maker (AMM). This is the time where liquidity pools play their best role as they do not need a professional, centralized market maker to manage the prices of assets. Liquidity providers simply deposit their assets into the pool and the smart contract takes care of the pricing.

Liquidity Pool Exchanges:

Uniswap

Uniswap is the most famous fully decentralized protocol for automated liquidity provision on Ethereum. Uniswap liquidity pools use a simple formalized equation to drives unstoppable liquidity for thousands of users and hundreds of applications. This equation makes sure that the product of two supplied tokens always remains the same.

In Uniswap direct token-token swaps are not yet supported, so each trade occurs in two separate steps: first ETH buy transaction with the token to be swapped, then ETH sell transaction to buy the second token.

JustSwap

JustSwap has been launched recently by TRON Network. JustSwap is a decentralized exchange protocol on TRON for exchanges between TRC20 tokens. Unlike Uniswap, users can directly swap any two TRC20 tokens based on system price.

JustSwap is a direct competitor to Uniswap that aims to address the ETH increased gas fees due to the DeFi demand on the Ethereum network. With more TPS speed, JustSwap promises lower fees and instant settlement.


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Atiq Ur Rehman
Atiq Ur Rehman
Electronics Engineer with a passion to write about Disrupting Technologies like Blockchain. He joined Crypto-Economy in July 2019.
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