A Liquidity Pool is a crowdsourced collection of cryptocurrencies or assets locked in a smart-contract. It is used to facilitate trading on a decentralized exchange or other DeFi platforms.

The New Market Maker

In traditional finance and on a centralized exchange, a market maker is a person or entity that provides liquidity by placing both buy and sell orders. In DeFi, this function is automated by liquidity pools. Users who wish to trade do so by swapping assets from the pool, rather than by matching with a specific buyer or seller.

The funds for a liquidity pool are provided by users, known as liquidity providers (LPs), who deposit an equal value of two or more assets into the pool. For example, an ETH/USDC pool would require depositing equal values of ETH and stablecoin to provide liquidity. In return for providing their assets, LPs earn a portion of the trading fees generated by the pool. This process is a key component of yield-farming.

The Risks of a Liquidity Pool

While liquidity pools offer opportunities for passive income, they come with a significant risk called impermanent loss. This occurs when the price of the assets you provide to the pool changes relative to each other. When a user withdraws their assets, they might have been better off simply holding the assets in their wallet rather than providing them to the pool. There are also risks of bugs or exploits in the underlying smart-contract, which could lead to a total loss of funds.

The Cornerstone of DeFi

Liquidity pools are the backbone of the DeFi ecosystem. They enable decentralized trading, lending protocols, and automated price discovery without the need for a central intermediary. They have played a crucial role in making Web3 a reality by democratizing access to financial services.