What is a Liquidity Pool?

Liquidity pools are pools of tokens locked in smart contracts that provide liquidity on decentralized exchanges in order to alleviate the problems caused by illiquidity. Liquidity pools are also the name given to the intersection of orders that form price levels that indicate whether the asset will continue to move in an uptrend or downtrend.

Decentralized exchanges that leverage liquidity pools are the same ones that use automated market maker based systems. On such platforms, the traditional order book is replaced by pre-funded on-chain liquidity pools for both assets of the trading pair.

The advantage of using liquidity pools is that it does not require the buyer and seller to decide to trade two assets for a given price and instead utilizes a pre-funded liquidity pool. This allows trades to occur with limited slippage for even the most illiquid trading pairs, as long as there is a large enough liquidity pool.

Funds held in liquidity pools are provided by other users who earn passive income from their deposits through transaction fees based on the percentage of the liquidity pool they provide.

Another emerging DeFi sector is insurance against smart contract risk. Most of its apps are also backed by liquidity pools.

Liquidity pools are one of the key mechanisms behind current DeFi technology. It provides decentralized commerce, lending, yield generation and much more. These smart contracts also power nearly every part of DeFi.

One of the first decentralized exchanges to introduce such a system was the Ethereum-based trading system Bancor, but it was widely adopted around the world after Uniswap popularized them.