What Is A Liquidity Pool?
A liquidity pool is an assortment of cryptocurrencies locked within a smart contract that provides liquidity for various types of transactions on decentralized finance (DeFi) protocols.
Decentralized exchanges (DEXs) are the most popular users of liquidity pools. They replace the traditional order book process with an on-chain, pre-funded liquidity pool based on both assets within a trading pair.
Most DEXs use automated market-maker (AMM) based systems that abandon the middle man in financial transactions. AMMs are more peer-to-contract over peer-to-peer systems, as the trade is executed against the liquidity where another peer isn’t required.[1]Binance Academy – What Are Liquidity Pools in DeFi and How Do They Work?
Taking crypto from the pre-funded liquidity pool minimizes slippage and significantly speeds up transaction time, compared to order-based transactions on a blockchain.
Why Are Liquidity Pools Needed?
Decentralized finance (DeFi) liquidity pools emerged to combat liquidity problems on DEXs as liquidity is a vital factor in a healthy market environment as it enhances the buying and selling process.
DeFi relies on users to provide liquidity, liquidity providers (LPs) will deposit cryptocurrencies into the smart contract, getting paid interest in return. Any user can become an LP, by depositing funds to their desired liquidity pool. This is in direct contrast to centralized entities like banks that act as huge market makers (liquidity providers) in traditional financial markets.[2]JP Morgan – DISCLOSURE TO WHOLESALE FIXED INCOME, CURRENCY, COMMODITIES AND EQUITIES PRODUCTS CLIENTS
Although liquidity pools are used namely with AMMs, they’re also utilized by various decentralized applications (dApps) including trading, lending, yield farming, and on-chain governance.
How Much Liquidity Is There?
Liquidity is represented by the total value locked (TVL) within DeFi protocols. Currently, in June 2022, there is US$106 billion TVL across all DeFi protocols.[3]DeFi Llama – Decentralized Finance Analytics
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