Liquidity pools

What is liquidity? Basically, the term ‘liquidity’ in crypto shows how convenient it is to swap one asset for every other or convert a crypto asset into fiat money. Liquidity is an integral element for all operations in DeFi, such as token swaps, lending or borrowing. Low liquidity tiers for a precise token lead to volatility, prompting extreme fluctuations in that crypto’s swap rates. Conversely, excessive liquidity capacity that heavy rate swings for a token are much less likely.

What is a liquidity pool? Liquidity pools occupy a massive and essential area in the DeFi ecosystem. A liquidity pool is essentially a reserve of a cryptocurrency locked in a smart contract and used for crypto exchanges. Each liquidity pool consists of two tokens, that’s why liquidity pools are also referred to as pairs. One of the liquidity pools’ most famous use cases are decentralized exchanges running on the automatic market maker (AMM) model. As adversarial to traditional, order-book exchanges, on AMM-based DEXes, traders change crypto with smart contracts instead of with each other and fees are primarily based on mathematical formulas.

Say a person needs to swap token A for token B on an AMM-based DEX. So, the consumer goes to the DEX's A-B liquidity pool, chooses the quantity of A they want to swap and receives token B. But, for customers to be capable to swap any quantity of A or B at any time, the pool has to have enough quantities of A and B tokens – or, in different words, it needs to have deep liquidity for each of the pool’s tokens. Therefore, each and every DEX running on the AMM tries to have as much liquidity provided as possible.

Liquidity can be provided by anyone holding a liquidity pool pair of tokens and DEX's incentivize liquidity providers by distributing among them a share of fees they earn from transactions made on their platform.