What is a Liquidity Pool?
A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools facilitate decentralized trading, lending, and many more functions we’ll explore later.
Liquidity pools are the backbone of many decentralized exchanges (DEX), such as Pancakeswap. Users, called liquidity providers (LP), add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades in their pool, proportional to their share of the total liquidity.
Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without requiring an order book. As no direct counterparty is needed to execute trades, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges.
You can think of an order book exchange as peer-to-peer, where the order book connects buyers and sellers.
Trading using an AMM is different. You could think of trading on an AMM as a peer-to-contract.
A liquidity pool is a collection of funds deposited into a smart contract by liquidity providers. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity of the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool.
When buying the latest token on a DEX, there isn’t a seller on the other side in the traditional sense. Instead, your activity is managed by the algorithm that governs what happens in the pool. In addition, pricing is also determined by this algorithm based on the trades that happen in the pool.