What Are Liquidity Pools in DeFi and How Do They Work? | Binance Academy - Deepstash
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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.

  • Liquidity Pools are the game-changing innovation in Decentralized Finance (DeFi) that facilitates trading on Decentralized Exchanges (DEX) and provide liquidity through a collection of funds locked in a smart contract.
  • Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool.

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Liquidity pools vs. order books

  • The order book is a collection of the currently open orders for a given market.
  • The system that matches orders with each other is called the matching engine. Along with the matching engine, the order book is the core of any centralized exchange (CEX). This model is great for facilitating efficient exchange and allowed the creation of complex financial markets.
  • Each interaction with the order book requires gas fees, which makes it much more expensive to execute trades.

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How do liquidity pools work?

How do liquidity pools work?

Automated market makers (AMM) have changed this game. 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.

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.

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What are liquidity pools used for?

Pooling liquidity is a profoundly simple concept, so it can be used in a number of different ways.

  • One of these is yield farming or liquidity mining. Liquidity mining has been one of the more successful approaches. 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.
  • Another emerging DeFi sector is insurance against smart contract risk. 
  • Another, even more cutting-edge use of liquidity pools is for tranching.
  • Minting synthetic assets on the blockchain.

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The risks of liquidity pools

  • If you provide liquidity to an AMM, you’ll need to be aware of a concept called impermanent loss. In short, it’s a loss in dollar value compared to HODLing. If you’re providing liquidity to an AMM, you’re probably exposed to impermanent loss. 
  • Another thing to keep in mind is smart contract risks. When you deposit funds into a liquidity pool, they are in the pool.
  • Be wary of projects where the developers have permission to change the rules governing the pool. Sometimes, developers can have an admin key or some other privileged access within the smart contract code.

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