What Is a Liquidity Pool?
A liquidity pool is essentially a pool of tokens that are locked by a smart contract. The main purpose of these pools is to help provide liquidity and facilitate trading on exchanges. They do this by giving users of the exchange a means to buy and sell.
As such, liquidity pools are used by Automated Market Markers (AMM) to minimize drastic price changes (volatility) on crypto exchanges. This characteristic makes liquidity pools ideal for new coins or tokens that do not have a large user base.
Bancor and Uniswap are among the most popular services to use liquidity pools.
A Deeper Look at this term
Standard crypto exchanges, like Binance and Coinbase, use the traditional order book system. In this model, sellers try to sell their crypto assets for as high as possible, while buyers try to purchase crypto for as low as possible. The order book then tries to match compatible buy orders with sell orders.
However, for a successful trade to happen, buyers and sellers have to converge on price. There is a high possibility that this will happen on exchanges with high volumes, i.e., exchanges with lots of buying and selling activity.
With new and unpopular coins (i.e., coins with little buying and selling activity), there may be large disparities between the buying and selling price as users typically list their assets for unrealistic buying and selling prices. Therefore, the order book will not be able to match compatible buyers and sellers, resulting in low liquidity. This is where liquidity pools come in.
To participate in a liquidity pool, persons need to deposit a trading pair of crypto assets in the pool. These pairs must usually be in equivalent value/proportions. For example, if someone wants to add liquidity to the ETH/DAI pool, for every 1 ETH they deposit, they must also deposit the USD equivalent in DAI.
Liquidity providers are incentivized for contributing to the pool by receiving a portion of the trading fees every time a trade occurs. For example, if the trading fees on an exchange are equal to 0.5%, and the amount of tokens they contributed to the pool equals 1%, then they will receive 0.5% of the 1% trading fee.
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