What a liquidity pool is
What are liquidity pools? How do they work? Why are they even needed in decentralized finance? What are the differences between liquidity pools under different protocols? We will cover all these questions in this article.
Liquidity pools are basically token pools that are locked in a smart contract. They are used to facilitate trading by providing liquidity and are widely used by some decentralized exchanges, also known as DEXs.
One of the first projects to introduce liquidity pools was Bancor, but they got widespread popularity thanks to Uniswap.
Before we explain how liquidity pools work from a technical point of view and what automated marketing is, it is better to understand why we even need them.
Why liquidity pools are needed
If you are familiar with any standard cryptocurrency exchanges such as Coinbase or Binance, you may have seen that their trading is based on an order book model. That is how traditional stock exchanges like NYSE or Nasdaq work.
The order-book model is essentially dependent on the presence of a market-maker or multiple market-makers who are always ready to “make the market” for a particular asset. The exchange instantly becomes not liquid and absolutely useless for ordinary users without market-makers.
That is why the UWIM decentralized exchange will work with liquidity pools for each token and pair.
How liquidity pools work
One liquidity pool contains 2 tokens in its core form, and each pool creates a new market for that particular pair of tokens.
When a new pool is created, the first liquidity provider is the one that sets the initial price of the assets in the pool. The liquidity provider is encouraged to provide the pool with an equal value for both tokens. If the initial price of the tokens in the pool differs from the current market price, it creates an instant arbitrage opportunity that could result in a capital loss for the liquidity provider. This concept of providing tokens in the correct ratio remains the same for all other liquidity providers that will want to add more funds to the pool later.