What is a Liquidity Pool?

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Understanding Liquidity Pools

A liquidity pool is a smart contract that holds two or more tokens and establishes a swap rate at which the held tokens can be swapped by traders. Tokens in liquidity pools are initially provided by users, known as liquidity providers, who earn a proportionate share of the liquidity pool swap fee as a yield.

Here's a breakdown:

Purpose

The heart of DeFi is liquidity pools; all decentralized trading happens through one or more liquidity pools. Liquidity pools are used to facilitate trading on decentralized exchanges (DEXs) without needing a traditional order book.

How It Works

When you trade on a DEX, you are trading using the liquidity in various liquidity pools on that DEX. The prices are determined by a algorithms, not by matching buyers and sellers via an orderbook.

Swap Rate

Different kinds of smart contracts and deployment configurations have varying algorithms that determine the swap rate of the tokens in the liquidity pool based on buys and sells into the pool from traders.

Benefits for Providers

Liquidity providers earn a share of the trading fees paid by traders who use the liquidity pool for swapping tokens, proportional to their share of deposited TVL, to get a yield.

Benefits for Traders

• Allows for full self-custody without requiring a third party to hold the funds.

• Guaranteed rates.

• Often better swap rates using DEX aggregators, which automatically get the best rate off every DEX, often better than a single centralized exchange (CEX).

For example, users that provide liquidity to a pool with Ethereum (ETH) and USDC, would deposit both tokens. In return, they would earn a portion of the fees whenever ETH for USDC is swapped or vice versa out of the liquidity pool.