Liquidity Pools Basic Overview

What is a liquidity pool?

A liquidity pool is a collection of funds locked behind a smart contract. These pools are the backbone of many decentralized exchanges (DEXs). Users provide liquidity, depositing an equal value of two crypto currencies in a pool to create a market. In exchange for providing their funds, the user earns trading fees from the trades that happen in the pool, proportionally to their ownership share of the pool. As anyone can be a liquidity provider, AMMs (Automated Market Makers) have made market making more accessible. One of the first protocols to use liquidity pools was Bancor, but the concept gained popularity with Uniswap, Sushi Swap, and Curve.

How do liquidity pools work?

They are a significant innovation that allows for on-chain trading without the need for an order book. 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. You can think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book. An example of this can be seen in Muesliswap. Whereas when using an AMM, your order doesn't need to be matched with another user making an order. Users can swap between currencies at wil; and the liquidity pool manages the price.

What are liquidity pools used for?

Essentially, liquidity pools are a way for users of crypto currencies to supply funds, so that services can be run on the blockchain. These services can vary, and theoretically with enough creativity, should be able to encompass the entire financial industry. For the purpose of our discussion, we will be focusing on liquidity pools used for exchanging between tokens (Swaps). To run an exchange, funds are required for users to swap between. As is the case in classical finance, when an exchange takes place at the bank, the bank takes a fee for facilitating that exchange. Similarly, when a user exchanges using a liquidity pool, the liquidity providers are paid a fee for allowing the exchange. It takes time for these fee’s to accrue, and due to risk held while waiting for these to be earnt (principally impermanent risk), platforms offer rewards for users in exchange for providing liquidity. This is called liquidity mining.
Liquidity Mining To create a better trading experience, various protocols offer even more incentives for users to provide liquidity by providing more rewards for particular “incentive” pools. In return for supplying these pools, the users are rewarded with the token of the particular protocol they are supplying. There are many different DeFi markets, platforms, and incentivized pools that allow you to earn rewards for providing and mining liquidity. So how do I liquidity mine? It is very simple! All you need to do is supply liquidity to a smart contract. In return, you will receive an LP token (This stands for liquidity pool token, and represents your ownership share of the entire liquidity pool). You then stake this LP token, and there you have it! You are liquidity mining.

Swaps and Liquidity Pools

Swapping and Liquidity Pools are the core fundamentals of DeFi. Token Swaps are a method of trading tokens on the Cardano Network using an AMM (Automated Market Maker) and Liquidity Pools. Swapping is the act of instantly trading tokens for tokens. The following explanation is for AMM DExes, not Order Book DExes. In order to swap, we first need Liquidity. This is done by users providing both sides of the pair to the platform. The user is incentivized via a share of the fees. When a swap occurs, the AMM will perform the sale to the system. The user is effectively buying from, or selling to, the decentralized liquidity pool.