What is a liquidity pool? What does decentralized finance mean by pooling liquidity in traditional financial services? " />

When it comes to liquidity pools, the first thing to understand is their definitions. It is basically a variety of funds locked in smart contracts. Liquidity pools can facilitate different types of transactions, such as decentralized loans and transactions, and many other functions. They are the basis of various decentralized exchanges or dexes such as Uniswap.

Some users called liquidity providers can add the equivalent of two tokens in a specific pool to create a market. Liquidity providers can earn transaction fees from all transactions in their capital pools. Interestingly, transaction costs directly depend on their share of total liquidity. The process of becoming a liquidity provider is easier, which also improves the accessibility of market making through automated market makers (AMMs).

The next key factor in understanding the value of liquidity pools is the need for liquidity pools. Similar to traditional stock exchanges, centralized crypto exchanges follow the order book model, which enables buyers and sellers to place orders. In the order book model, the buyer's goal is to buy assets at the lowest possible price, while the seller focuses on selling assets at the highest possible price.

Now, the buyer and seller should agree on the price of a successful transaction. However, when the buyer and seller cannot agree on the price, you may encounter some setbacks. In addition, concerns about liquidity also pose obstacles to the execution of transactions. In this case, market makers find a perfect window and secure transactions by promising to buy or sell specific assets. Therefore, they can provide liquidity.

In addition to providing liquidity, market makers can also help traders trade without waiting for other buyers or sellers. However, over reliance on external market makers can lead to extremely slow and expensive trading. The liquidity pool concept in DeFi can play a decisive role in solving these problems.

Automated market makers have become a powerful factor in changing the traditional crypto asset trading methods. AMM has developed into a driving force for innovation and can conduct transactions on the chain without any order book. Without any direct counterparty to execute the transaction, you can easily access the positions of token pairs.

AMM ensures greater flexibility of token pair trading. In the exchange following the order book model, the liquidity of token pair is quite poor. Order book exchange allows peer-to-peer transactions to establish a connection between buyer and seller through the order book. However, AMM transactions are different because they focus on interactions between peers and contracts.

A liquidity pool is basically a collection of funds deposited into a smart contract by a liquidity provider. AMM transactions do not involve any counterparties, and users must trade in terms of liquidity. If the buyer wants to buy, they do not have to rely on the seller at a particular time. On the contrary, sufficient liquidity in the pool can support the execution of the transaction.

When you buy the latest food coins on Uniswap, there are no sellers on the other side. In fact, one algorithm is responsible for pool governance while managing the entire transaction. In addition, the algorithm also uses the information of different transactions in the pool, thus playing an important role in pricing.

Another interesting fact about the liquidity pool DeFi is that anyone can become a liquidity provider. Therefore, in this case, it is reasonable to assume that the liquidity provider is the counterparty, and there is no exact similarity with the order book model.

summary

The above is an explanation of what is the liquidity pool in DeFi. The working capital pool is the most important innovative technology intervention in the encryption field in recent years. They play a crucial role in driving the viability of the existing DeFi technology stack. The working capital pool can also promote a wide range of use cases in the DeFi field, including decentralized transactions, income agriculture, lending, etc.