What is a liquidity pool?
A liquidity pool is essentially a blockchain-based smart contract designed to lock tokens on a decentralized exchange. The liquidity added to a pool is secured within the smart contract.
Liquidity pool is providing the necessary assets for traders to execute transactions. Liquidity providers are rewarded with a share of the trading fees paid by those who swap tokens within the pool, proportional to their contribution.
The traditional order book system works well when there are sufficient buyers and sellers in the market. However, in cases of low volume or interest, tokens may lack liquidity, making them difficult to trade. Without a market maker, a trade can quickly become illiquid.
Liquidity pools operate through trading pairs, where each pool creates a market for a specific token pair via a blockchain-generated smart contract. This system enhances the liquidity of tokens and assets traded on DeFi-based exchanges, but it requires incentives for liquidity providers to deposit assets.
The process works as follows: The initial liquidity provider sets the starting price of the assets in the pool. Providers are encouraged to deposit equal amounts according to the current price, ensuring their contributions do not impact the token’s value within the pool. In return, they receive LP tokens proportional to their deposit. When trades occur, fees are collected and distributed among LP token holders.
Price fluctuations in the pool, caused by trades, lead to changes in the supply of assets. This is managed by an algorithm known as an automated market maker (AMM), which eliminates the need for a centralized market maker or professional asset management. Traders can simply use the DEX platform to execute transactions without monitoring order books or price charts.
Furthermore, DEX platforms typically offer lower gas costs compared to centralized exchanges, thanks to the efficient design of their smart contracts.
