What are liquidity pools?

In financial markets such as foreign exchange markets, stock markets, bond markets, there needs to be some mechanism for providing liquidity so that trade in the asset can take place. Liquidity in cryptocurrency markets essentially refers to the ease with which tokens can be swapped to other tokens (or to government issued fiat currencies).

One way a market achieves liquidity is through the use of order books, like in a stock market. Here buyers and sellers of an asset place orders: they specify a price and quantity of the asset that they would like to buy or sell, as the case may be. An exchange, such as a stock exchange, then matches buy and sell orders to establish a price for the asset.

How do centralised exchanges work?

Centralised exchanges in the cryptocurrency ecosystem that implement an order book system carry over all the problems of centralisation in traditional finance, which can make them unattractive. However, decentralised order books have been found to be expensive to implement on a blockchain.

What is a market maker?

An alternative way to provide liquidity is through the use of a market maker, an agent who stands ready to buy and sells certain assets at all times, thereby providing liquidity to the market. In DeFi, there exist centralized exchanges, such as Binance (which is a firm), that act as market makers. However, one of the exciting new aspects of DeFi is the replacement of a centralized market maker with a decentralised counterpart. So, instead of using a centralised exchange like Binance to swap tokens, you can use a decentralised exchange (DEX) like Uniswap.

How do liquidity pools work?

A liquidity pool is a smart contract where tokens are locked for the purpose of providing liquidity. Some of the important concepts required to understand how liquidity pools and decentralised exchanges work include liquidity providers, liquidity tokens and automated market makers.

Liquidity pools are used not only by decentralised exchanges to swap tokens, but also for borrowing and lending activities. As such, they play an important role in the DeFi ecosystem.