A liquidity pool is a collection of capital locked away in a smart contract.
These pools of liquidity (money) are used to facilitate decentralized lending,
trading, and other DApps used in the DeFi ecosystem.
Instead of central institutions providing capital for loans, smart contracts are used to distribute and collect capital for borrowers and lenders. All activities on liquidity pools are governed by smart contract code, removing
the risk of human error and intervention when dealing with large funds.
“ It is a reservoir of crypto funds mostly in pairs, which works based on the smart contract rules , facilitating user to engage in decentralized, permissionless trading, lending, borrowing activities and in turns getting rewards in the form of the crypto.”
Decentralized exchanges like UniSwap, Sushipswap, Curve, Balancer use the concept of liquidity pooling, to fuel their market. Dex participant willing to act as a Liquidity provider(LP), pools their token in pair to create a market, they get trading fee as a reward for facilitating transactions like token swapping, lending, borrowing, etc, happening against their pool. These rewards are proportional to their share of the total liquidity provided.
Advantages of Liquidity Pools
The primary advantage of LPs is that you don’t have to worry about finding a partner that values crypto in the same way you do.
If you’ve ever tried cryptocurrency trading, you’ve definitely come across investors who want to sell it for excessively high prices or acquire it for shallow ones. You’ll need outstanding negotiating abilities and a strong sense of character to win. Unfortunately, these aren’t available to everyone.
Liquidity Pools, on the other hand, modify the value of cryptocurrencies dependent on the platform’s exchange rate.
Transactions are much smoother now that there are no sellers demanding double the market price or purchasers willing to discount it below average.
A Liquidity Pool is a pile of assets locked in a smart contract and whose values are automatically updated based on exchange rates.