Decentralized Finance (DEFI) is reaching new heights day by day, An Important concept of DEFI exchanges are the liquidity pools, which keep the trading going.So what are liquidity Pools ?
Liquidity
Well, First we need to understand what is liquidity.It can have a different meaning for different things, but let's just focus liquidity for markets right now.In stock exchange the trade should keep on going, but what if the seller and buyers refuse to buy or sell on certain price, then it there will be a deadlock, the market will freeze as not trade will be happening.
This is where liquidity providers come in place, the provide liquidity to the market so that trade keeps on happening . Liquidity means buyers and sellers are always available for trade.
The Order Book Model
Order Book Model follows centralized way for trading.In this model buyers and sellers come together and place these orders.Buyers try to buy a certain asset at the lowest price, and seller try to sell at the highest price.Market makers facilitate by always willing to buy and sell certain assets, thus providing liquidity
In DEFI, this process is very slow, expensive and results in poor user experience, The Order Book model relies heavily on market makers or multiple market makers.This results huge numbers of orders and order cancellations. Ethereum has a current throughput of 12-15 transactions per/second.Block Time of 10-19 seconds is not an viable option for an order book exchange.Every interaction with a smart contract costs a gas fee, so market makers will just bankrupt by there orders..
Liquidity Pools
In an decentralized exchange liquidity pools take place as market makers and facilitate the trade to keep moving.Liquidity pools hold two tokens and each pool creates a new market for particular pair of tokensThe biggest advantage of Liquidity Pools is that it does not require any market maker instead the facilitated through liquidity pools.The pools consist of Liquidity Providers, who are simply the users who deposited there assets in the pool and earn some profit from it.Some prominent protocols for liquidity pools are
- UniSwap
- Balancer
- Curve
LP TOKENS
When a liquidity is supplied to a pool, the liquidity provider receives special tokens called LP Tokens, in proportion to how much liquidity they provide to the pool.Fixed Amount of fee is distributed among all LP Token Holders and if an LP wants to get back there liquidity, they must burn there LP Tokens
UNISWAP
Uniswap is an decentralized exchange protocol, in which liquidity for exchange transactions is provided in the form of on-chain pools.Trades are executed against these pools, which uses Automated Market Making strategy to enable exchange free of order of books.The prices of the token depends on the desired quantity, the more people buy it, the more expensive it becomes.The most prominent example for Uniswap is DAI/ETH.
So that is a basic intro to the liquidity Pools, for better understand i recommend you checking Uniswap and balancer.