What are Liquidity Pools?

In this article, you’ll learn all about what liquidity pools are in crypto. 

However, before you can fully understand what liquidity pools are, it’s important you understand what liquidity means.

So, what is liquidity?

Liquidity is an essential aspect of both cryptocurrency and financial markets. As such, you won’t be able to efficiently operate or excel in crypto without an understanding of liquidity and liquidity pools.

Liquidity, in simplest terms, refers to the ease with which an asset can be bought or sold without significantly impacting its market price. It means that any system or market that’s referred to as ‘more liquid’ simply means it’s easier for money to flow through and around it. 

Can you imagine how much water is in a mountain stream after a heavy downpour? Clearly, a lot more than usual - and if you think about it, that is essentially how liquidity works, too.

Liquidity enables assets to be converted into cash rapidly and smoothly. In turn, this also means it helps avoid any extreme price fluctuations in markets. 

Now that you know what liquidity means, let us look at the concept of liquidity pools in detail.

Now you’re probably wondering “What are Liquidity Pools?”

Creating a liquid decentralized finance system relies heavily on liquidity pools. These Liquidity pools provide liquidity through funds which are locked into smart contracts. It's these pools which enable decentralized trading, yield farming, lending, arbitrage trading, and profit-sharing.

Centralized markets have long been able to run trades and exchanges successfully, particularly traditional stock exchange markets. Have you ever wondered how it happens? 

In fact, a liquidity pool operates in a similar way to a market maker in traditional stock exchange markets. In stock exchange markets, a market maker is a firm or individual that stands ready to buy and sell a particular stock regularly. This market maker continuously trades at a publicly quoted price. They help ensure that there is always a buyer and a seller available for a particular stock, which in turn makes the market more liquid. 

Thanks to market makers, despite every trade requiring a counterparty, there always seems to be one readily available. These market makers are clearly critical in ensuring traders can always execute their orders, by holding significant positions in assets such as stocks, as it’s these assets which they offer to traders.

How does this map to Exchanges? 

The bid is the price at which market makers are willing to buy assets, while the ask is the price at which they are ready to sell them. To make a profit, market makers create a slight price discrepancy between the bid and ask price, known as the bid-ask spread.

Since market makers possess large quantities of assets, they assist trading platforms in matching buyers with sellers quickly. The liquidity provided by market makers ensures that traders can always execute their trades at the agreed-upon price.

In cryptocurrency, a liquidity pool refers to a collection of funds allocated for buying and selling cryptocurrencies on a decentralized exchange. Multiple individuals can contribute cryptocurrency to the pool and receive a share of the fees generated by transactions. The liquidity pool guarantees the availability of buyers and sellers for a specific cryptocurrency on the exchange. In the end, it enhances market liquidity.

Liquidity pools ensure that buy and sell orders are executed at any time and at a trader’s desired price without needing a direct counterparty. The availability of a seller is not required to buy a token as long as there is sufficient liquidity in the pool.

But it’s the 21st century, right? Haven’t there been any improvements since Wall Street in the 20s? 

Some innovations Liquidity Pools Offer

Decentralized exchanges on Ethereum used to face significant liquidity challenges in their early days. The limited number of buyers and sellers made it difficult to maintain high market liquidity.

However, the introduction of Automated Market Makers revolutionized the market by establishing more consistent liquidity pools. These automated market makers incentivized individuals and organizations to provide liquidity by rewarding them with assets for their contributions. All of this is accomplished without requiring human intervention from third parties.

Stock traders understand that the larger the pool of assets, the greater the level of liquidity, making trading on exchanges easier. The automatic market maker algorithm adjusts the price to guarantee that the pool always has enough liquidity, regardless of the trade size.

Let me break it down further. Imagine if a liquidity pool has a 50:50 distribution of two coins, such as 50% bitcoin and 50% ether. If you purchase bitcoin using ether, the pool will experience a decrease in bitcoin and an increase in ether. To maintain the set ratio, the algorithm adjusts the price of bitcoin upward and the price of ether downward. This process is a self-regulating and automated response to the market’s demands.

So, all sounds good in principle but - who actually puts up the funds to enable liquidity pools in the first place?

Introducing… Liquidity Providers

Liquidity providers are companies or individuals that deposit cryptocurrency tokens into liquidity pools to earn transaction fees. This process is also known as liquidity mining or market making. The fees earned are determined by the pool’s liquidity amount and the number of transactions taking place.

Liquidity providers help make trading easier by offering both buying and selling options. This allows traders to make transactions quickly and at desirable prices. They add equal amounts of two tokens to the pool and earn trading fees based on their share of the total liquidity.

You are probably wondering, who can be a liquidity provider? Well, anyone can!

With automated market makers, anyone can participate in market making. This has made it more accessible for people to get involved in trading cryptocurrencies. Additionally, crypto liquidity providers have advanced risk management systems, ensuring smooth and secure transactions for traders looking to move funds in and out of crypto exchanges.

Where can I see this in action?

Uniswap has emerged as a very well-known decentralized exchange, with a huge amount of crypto assets in its liquidity pools. Uniswap built its protocol on Ethereum and uses smart contracts to manage these pools, letting investors trade cryptocurrencies directly from their Ethereum wallets. 

Similarly to Uniswap, some other decentralized exchanges such as SushiSwap, Curve, and Balancer also utilize liquidity pools on Ethereum. But there are decentralized exchanges outside of Ethereum too. On the BNB Smart Chain, PancakeSwap, BakerySwap, and BurgerSwap are also popular decentralized exchanges that employ their own liquidity pools.

If there are no liquidity providers, a decentralized exchange won’t function properly and people won’t be able to sell or buy tokens as they wish. Liquidity providers are absolutely essential and for more than just one reason.

Advantages of Liquidity Pools in Crypto

One benefit of liquidity pools is they make trading simpler. They eliminate the need to find someone who shares your valuation of a particular cryptocurrency. Many traders in the cryptocurrency space have unrealistic expectations and set high prices for sales while seeking low prices for acquisitions. The absence of a centralized exchange in liquidity pools can improve privacy and efficiency in trading activities.

Another benefit of liquidity pools is that they let you earn passive income as a liquidity provider. Liquidity pools allow liquidity providers to essentially earn interest on their digital assets, in the form of shared transaction fees. 

By depositing tokens into a smart contract, you can earn a share of fees generated from trading activities within the pool. This reward system incentivizes users to supply liquidity to the pool, which ensures enough liquidity to support trading activities on decentralized exchanges.

Of course, liquidity pools have some drawbacks. 

Any Downsides of liquidity Pools?

Unfortunately, liquidity pools do come with their fair share of issues. 

The first problem is known as impermanent loss. This issue arises when the ratio of two assets held in a liquidity pool becomes uneven, due to a sudden price surge in one of them. 

As a result, as a liquidity provider, you may lose profits from one of the assets you put into the pool. This loss can become permanent if you withdraw funds from the pool before the affected asset’s price recovers.

Another problem of liquidity pools is Smart Contract Vulnerabilities. Smart contracts govern pool assets, with no central authority or custodian responsible. This means that if a vulnerability exists, assets could be lost permanently. 

Conducting smart contract audits is a reliable way to help strengthen the security of smart contracts against cyber threats. This procedure does, however, involve closely examining the source code to detect potential weaknesses.

The last problem with liquidity pools is the issue of developers hijacking them. In centralized liquidity pools, a developer may take control of the pool, leaving liquidity providers with limited options. Just as when you invest in traditional assets, it is crucial to exercise caution when selecting a liquidity pool. 

You must conduct appropriate due diligence before depositing your funds and digital assets, to avoid putting your crypto in fraudulent projects.


In this video, you’ve learned the concept of liquidity pools in crypto. 

You saw what liquidity means, the importance of liquidity pools and the role of liquidity providers. 

You also learned that liquidity pools help create a more liquid decentralized finance system. This includes aspects such as trading, cryptocurrency yield farming, lending, arbitrage trading, and profit-sharing. Innovations like automated market makers have revolutionized the market, allowing anyone to become a liquidity provider, including you!

Liquidity pools offer several benefits, including making trading easier and providing passive income for liquidity providers. However, you need to be careful with challenges such as impermanent loss, smart contract vulnerabilities, and the risk of developers hijacking pools. 

It's crucial to exercise caution when you select a liquidity pool, so always conduct appropriate due diligence before depositing funds and digital assets to avoid potential issues! Good luck out there!

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