Contents
- Introduction
- What is liquidity pool
- How does it work
- Examples
- Terms to note
Introduction
Decentralized Finance (DeFi) has created an explosion of on-chain activity. DEX volumes can meaningfully compete with the volume on centralized exchanges. As of December 2020, there are almost 15 billion dollars of value locked in DeFi protocols. The ecosystem is rapidly expanding with new types of products. But what makes all this expansion possible? One of the core technologies behind all these products is the liquidity pool.
What is liquidity pool?
A liquidity pool refers to a collection of tokens or digital assets locked in a smart contract that provides essential liquidity to decentralized exchanges.
They are smart contract that allows traders to trade tokens and coins even if there are no buyers out there. Liquidity pool plays a large part in creating a liquid decentralized finance ( DeFi)
How does it work
A major component of a liquidity pool are automated market makers(AMMs). An AMM is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.
To paint a clearer scenario Imagine waiting to order inside a fast-food restaurant. Liquidity is comparable to having lots of cashiers. That would speed up orders and transactions, making customers happy. On the other hand, illiquidity is comparable to having only one cashier with a long line of customers. You know that would lead to slower orders and slower transactions, creating unhappy and unsatisfied customers
In addition, a smart contract is a technology that allows liquidity pools to exist. It is interesting to know that a typical liquidity pool starts off with an exact ratio of 50:50, 50% of Ethereum, and 50% of basic attention tokens.
In summary, a liquidity asset provides a bunch of digital assets for people to trade with and in turn, the liquidity pool providers get an incentive.
Examples of Liquidity Pool
One of the first protocols to use liquidity pools was Bancor, but the concept gained more attention with the popularization of Uniswap. Some other popular exchanges that use liquidity pools on Ethereum are SushiSwap, Curve, and Balancer. Liquidity pools in these venues contain ERC-20 tokens
Major terms to Note
Automated Market Makers (AMMs): An AMM is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.
Liquidity Providers(LP): Liquidity pools are designed to incentivize users of different crypto platforms, called liquidity providers (LPs)
Liquidity Provider Tokens (LPTs): LPs are rewarded with a fraction of fees and incentives, equivalent to the amount of liquidity they supplied, called liquidity provider tokens (LPTs). LP tokens can then be used in different ways on a DeFi network.