• About Us
  • Careers
  • Contact
No Result
View All Result
Saturday, July 26, 2025
DeFi Planet
  • News
    • People
    • Business
    • Crime
    • Regulation
    • Crypto
    • CBDC
  • Markets
    • Bitcoin
    • Ethereum
    • Stablecoins
    • Altcoins
    • Crypto ETFs
    • Memecoins
  • Policy
  • Articles
    • Press Releases
    • Opinion
    • Explainers
    • Guest Post
    • Sponsored
  • Directory
    • Companies
    • People
    • Products
    • Wallets
  • Multimedia
    • Videos
    • Podcasts
  • Learn
    • DeFi Basics
    • Tutorials
    • Reviews
    • Blockchain Fundamentals
  • Research
    • Case Studies
  • Explore
    • DeFi
    • Crypto Gaming
    • NFT
    • DAO
    • Metaverses
    • Glossary
  • Jobs
  • Markets Pro
    • DeFi Planet Pro
    • Spend Crypto
    • Swap Crypto
    • Coin Prices
    • Crypto Exchanges
    • Crypto Analyzer
  • News
    • People
    • Business
    • Crime
    • Regulation
    • Crypto
    • CBDC
  • Markets
    • Bitcoin
    • Ethereum
    • Stablecoins
    • Altcoins
    • Crypto ETFs
    • Memecoins
  • Policy
  • Articles
    • Press Releases
    • Opinion
    • Explainers
    • Guest Post
    • Sponsored
  • Directory
    • Companies
    • People
    • Products
    • Wallets
  • Multimedia
    • Videos
    • Podcasts
  • Learn
    • DeFi Basics
    • Tutorials
    • Reviews
    • Blockchain Fundamentals
  • Research
    • Case Studies
  • Explore
    • DeFi
    • Crypto Gaming
    • NFT
    • DAO
    • Metaverses
    • Glossary
  • Jobs
  • Markets Pro
    • DeFi Planet Pro
    • Spend Crypto
    • Swap Crypto
    • Coin Prices
    • Crypto Exchanges
    • Crypto Analyzer
No Result
View All Result
DeFi Planet
No Result
View All Result
Home Articles

What Are Liquidity Pools And How Do They Work?

6 August 2021
in Articles, DeFi Basics, Opinion
Reading Time: 7 mins read
126 2
What Are Liquidity Pools And How Do They Work | DeFi Planet

source: youtube

Contents

Toggle
  • What Is A Liquidity Pool?
  • Why Do We Need Liquidity Pools?
  • Liquidity Pools Vs Order Books
  • The Need For Liquidity Pools In DeFi
  • So why can’t we just do the same thing in DeFi?
  • How Do Liquidity Pools Work?
      • What does this imply?
  • Different Types Of Liquidity Pools
  • The Risk Of Liquidity Pools
  • In Conclusion…

Last updated on July 11th, 2023 at 11:18 pm

DeFi has blown up in the past year, and the on-chain activity has been rapidly increasing. The volumes have been so high recently that popular decentralized exchanges like Uniswap can even compete with the volume on some of the centralized exchanges. As of August 2021, there is almost $69 Billion in Total Valued Locked (USD) across DeFi protocols.

You must be wondering, what is the reason for such rapid growth of the niche? While many factors have contributed to the growth of DeFi, one factor that stands out is the number of funds locked in across liquidity pools in different DeFi protocols.

In this article, we will talk about what liquidity pools are and how they work. We will also talk about the importance of liquidity pools in DeFi and some of the risks associated with them.

Let’s dive in.

What Is A Liquidity Pool?

Liquidity pools are a collection of tokens that are locked in a smart contract. By providing liquidity to a platform, they facilitate trading, lending, and allow many other cool DeFi functionalities. 

The concept of liquidity pools is mostly used by decentralized exchanges or DEXes in the DeFi ecosystem. It is fair to say that liquidity pools are the backbone of these platforms as, without them, these platforms will essentially have no good reason to even exist.

Liquidity Pools are operated by Liquidity Providers or LPs. LPs are the market participants responsible for creating a liquidity pool by adding an equal value of two tokens in a pool. You must be thinking why would anyone just give their funds to a pool right? Well, the answer is pretty simple. It’s because of the benefits that they get. 

By providing liquidity to a liquidity pool, LPs can earn trading fees from all the transactions that take place in their pool. Their cut depends on the proportion of total liquidity they provide to the pool.

Since anyone in the world can become a liquidity provider on any platform in DeFi, DEXes have made the DeFi ecosystem more accessible. While Bancor was one of the first DEXes that introduced the concept of liquidity pools, the use of such pools was widely popularised by Uniswap. 

Why Do We Need Liquidity Pools?

If you have invested in crypto, you must be aware that centralized crypto exchanges like Binance or Coinbase allow users to trade on their platform. To facilitate trading, such platforms use the order book model, similar to the model used by TradFi exchanges like the NYSE.

Let’s try and understand how this model works.

Liquidity Pools Vs Order Books

To understand how the concept of liquidity pools is unique, let’s take a look at how trading works in the conventional sense.

Traditional finance exchanges use the concept of order books for trading purposes. An order book is a collection of all the open orders in a market. Using the matching engine system, all the orders in the market are matched and the data is reflected on the order book. 

In DeFi, there is no central authority that holds the funds of the users, thus, all the transactions are executed on-chain. This poses a problem for using the order book concept in DeFi as each transaction using the order book requires gas fees, making the trades more expensive. 

Moreover, this makes the process of providing liquidity less profitable for LPs. Furthermore, most blockchains that are currently available in the market do not have the capacity to handle the required throughout which would be generated from the billions of dollars in traded volume every day.

source: finematics

The Need For Liquidity Pools In DeFi

In the order book model, buyers and sellers on the platform come together and place their orders on the exchange. Buyers try to buy assets at the lowest possible price whereas sellers try to sell their assets at the highest possible price. For a trade to occur, both buyers and sellers need to agree on the price. This can only happen if either the buyer is willing to bid higher or a seller is willing to sell their assets at a lower price.

Seems fairly simple right? It is, but there’s a catch. What if neither the buyer nor the seller agrees to sell their assets at a ‘fair price’? This is why we need market makers. In TradFi, a central authority acts as a market maker to facilitate trading. These entities are always willing to buy or sell an asset at any price and by doing so, they provide the much-needed liquidity to the platform. In doing so, such entities allow trades to be executed instantly on the platform as neither the buyer nor the seller has to wait for someone to match their price.

So why can’t we just do the same thing in DeFi?

The same concept can be used in DeFi as well, but the system will be inefficient. This is because, in DeFi, there is no central authority that can act as a market maker and will always be willing to “make the market”. As a result, the exchange would become highly illiquid and the trading experience will be very slow and expensive.

Moreover, on TradFi platforms, there is a large number of orders and order cancellations as the market makers are constantly changing their prices to track the current price of an asset. Thus, for a blockchain like Ethereum, using an on-chain order book exchange does not make practical sense. Layer two solutions like Polygon provide an alternative to this but such networks have not yet become mainstream.

However, it is worth noting that there are many DEXes like the Binance DEX that work just fine using the on-chain order book concept. Moreover, blockchains like Solana make it possible for DEXes to enable fast and cheap trading.

How Do Liquidity Pools Work?

Now that we have a better understanding of why we need liquidity pools, let’s take a look at how they actually work.

Any Liquidity Provider can create a new liquidity pool by simply adding 2 tokens. The first LP sets the price of the assets in the pool and other LPs are incentivized to supply more liquidity to the pool by supplying an equal value of both tokens. 

The incentive for LPs is LP tokens that they receive in the proportion to the funds they add to the pool. When a trade is executed on their pool, the fee generated is distributed equally among all the LPs of that pool.

Since Automated Market Makers use a deterministic pricing algorithm, each token swap on a liquidity pool results in a price adjustment according to the algorithm. Most liquidity pools use a constant product model which is run on the formula x*y=k where x and y are the tokens of the pool. 

What does this imply?

This means that the ratio of the tokens in the pool determines the price. As the quantity increases, the algorithm of AMMs increases the price of the token. This allows pools to always be able to provide liquidity irrespective of the size of the trade.

Let’s look at an example to understand this better.

For instance, a user buys ETH from a USDC/ETH pool. When they do that, the supply of ETH in the pool reduces, and the supply of USDC increases. This results in an increase in the price of ETH and a decrease in the price of USDC. 

The extent of the price movement depends on the size of the transaction in comparison to the size of the pool. The larger the pool in comparison to the transaction size, the lesser the price change meaning that there is less slippage offering a better trading experience.

You can also check out our article on yield farming to understand how liquidity mining works.

Different Types Of Liquidity Pools

The liquidity pool mentioned above is the one used by Uniswap. This is how most liquidity pools work and are the simplest kinds of pools to understand. However, many different projects have come up with interesting twists on the conventional liquidity pool concept.

For example, Balancer has liquidity pools with as many as 8 tokens in a single liquidity pool whereas, Curve uses a different algorithm for different pools to offer lower fees and lower slippage wherever possible.

The Risk Of Liquidity Pools

Besides the standard DeFi risks such as smart contract bugs and systematic risks, users must be aware of risks such as impermanent loss and liquidity pool hacks.

In short, the impermanent loss is the loss in value that LPs face when they provide liquidity in comparison to just holding on to their asset.

You can learn more about the impermanent loss in DeFi  and how to avoid it.

In Conclusion…

Liquidity pools will lead the way for DeFi to grow in the future. By offering incentives to LPs, liquidity pools are attracting many users to DeFi and explore yield farming. 

What are your views on liquidity pools? Have you ever provided liquidity to one?

Let us know in the comments!

 

If you would like to read more articles like this, follow DeFi Planet on Twitter and LinkedIn.

Don't miss out!

Subscribe To Our Newsletter

Receive top education news, lesson ideas, teaching tips and more!
Invalid email address
Give it a try. You can unsubscribe at any time.
Thanks for subscribing!
Tags: BlockchaintechnologyCryptocurrencyDeFimarket
Share74Tweet47Share13
Arjun Chand

Arjun Chand

Related Posts

Beyond Bitcoin: Why Ethereum Deserves a Bigger Slice of Institutional Portfolios
Opinion

Beyond Bitcoin: Why Ethereum Deserves a Bigger Slice of Institutional Portfolios

23 July 2025
What is the Real Potential of the Open Network (TON)?
Project Reviews

What is the Real Potential of the Open Network (TON)?

23 July 2025
Is Browser-Based Crypto Mining Still Profitable in 2025?
Explainers

Is Browser-Based Crypto Mining Still Profitable in 2025?

23 July 2025
If Crypto Were Just Hype, It Would’ve Died Years Ago
Opinion

If Crypto Were Just Hype, It Would’ve Died Years Ago

23 July 2025

Featured Posts

What is a Crypto Order Book and How Does it Work?

What is a Crypto Order Book and How Does it Work?

byOlayinka Sodiq
14 July 2025
0

Elon Musk's xAI Colossus: What It Is and Why It’s a Big Deal?

Elon Musk’s xAI Colossus: What It Is and Why It’s a Big Deal?

byOlayinka Sodiqand1 others
12 July 2025
0

Is AI the Future of Crypto Trading or a Threat to Market Stability?

Is AI the Future of Crypto Trading or a Threat to Market Stability?

byOlajumoke Oyaleke
7 July 2025
0

What Are DeFi Options Vaults, and How Do They Work?

What Are DeFi Options Vaults, and How Do They Work?

byOlajumoke Oyaleke
26 June 2025
0

source: investorplace.com

How to Find the Newest Cryptocurrencies Before They’re Listed

byOlayinka Sodiq
30 December 2024
0

Read More

Chain of Thoughts

The Game-changing Triumvirate: Blockchain, Data Science, and Artificial Intelligence

The Game-changing Triumvirate: Blockchain, Data Science, and Artificial Intelligence

byOlu Omoyele
30 June 2025
0

...

Are Stablecoins Bank Deposits?

Are Stablecoins Bank Deposits?

byOlu Omoyele
31 May 2025
0

...

DAOs and the Coordination of Human Endeavour

DAOs and The Coordination of Human Endeavour

byOlu Omoyele
27 April 2025
0

...

Should DeFi Be Regulated?

Should DeFi Be Regulated?

byOlu Omoyele
27 March 2025
0

...

Markets Update

Your Weekend Crypto Roundup | July 2025 (Week 3)

1 week ago

Account Abstraction Adoption: Are Users Ready for Smart Wallets?

1 week ago

The Role of Real-World Assets (RWAs) in the Next DeFi Boom

2 weeks ago

Stablecoins in 2025: Still Depegging or Finally Stable?

2 weeks ago

Your Weekend Crypto Roundup | July 2025 (Week 2)

2 weeks ago

The Battle for Web3 Infrastructure: Which Platforms are Dominating in Decentralized Storage, Compute, and Identity?

3 weeks ago
Read More

Events

Rare Evo 2025
Rare Evo 2025
6 Aug 25
Las Vegas
CBDC Conference
CBDC Conference
9 Sep 25
Nassau

Spotlight

All about Ethereum
All about Algorand
All about Bitcoin
All about Gora

Press Releases

Pepeto Announces $5.5M Presale and Demo Trading Platform

bychainwire
25 July 2025
0

$75K in Rewards Announced for Valhalla’s First-Ever Tournament

bychainwire
25 July 2025
0

Bybit and Tether Launch Strategic Partnership to Accelerate Crypto Adoption in Brazil

bychainwire
25 July 2025
0

Remittix Presale Raises $17M After Revealing Next-Gen Web3 Wallet Beta Launch Date

bychainwire
25 July 2025
0

BioSig Technologies and Streamex: Pioneering Real-World Asset Tokenization in the U.S. Market

bychainwire
25 July 2025
0

Read More

ADVERTISING

ABOUT

TEAM

CAREERS

CONTACT

TERMS & CONDITIONS

PRIVACY POLICY

© Copyright 2025 DeFi Planet

Welcome Back!

Login to your account below

Forgotten Password?

Retrieve your password

Please enter your username or email address to reset your password.

Log In
Please enter and activate your license key for Cryptocurrency Widgets PRO plugin for unrestricted and full access of all premium features.

Add New Playlist

No Result
View All Result
  • News
    • People
    • Business
    • Crime
    • Regulation
    • Crypto
    • CBDC
  • Markets
    • Bitcoin
    • Ethereum
    • Stablecoins
    • Altcoins
    • Crypto ETFs
    • Memecoins
  • Policy
  • Articles
    • Press Releases
    • Opinion
    • Explainers
    • Guest Post
    • Sponsored
  • Directory
    • Companies
    • People
    • Products
    • Wallets
  • Multimedia
    • Videos
    • Podcasts
  • Learn
    • DeFi Basics
    • Tutorials
    • Reviews
    • Blockchain Fundamentals
  • Research
    • Case Studies
  • Explore
    • DeFi
    • Crypto Gaming
    • NFT
    • DAO
    • Metaverses
    • Glossary
  • Jobs
  • Markets Pro
    • DeFi Planet Pro
    • Spend Crypto
    • Swap Crypto
    • Coin Prices
    • Crypto Exchanges
    • Crypto Analyzer

© Copyright 2024 DeFi Planet   |   Terms & Conditions   |   Privacy Policy

-
00:00
00:00

Queue

Update Required Flash plugin
-
00:00
00:00