What is Liquidity Pool?
Let's find out Liquidity Pool meaning, definition in crypto, what is Liquidity Pool, and all other detailed facts.
Liquidity pool refers to the pool of tokens that are locked in smart contracts. They are used on decentralized exchange platforms (DEXs) to provide liquidity and mitigate the illiquidity issues of such platforms.
Liquidity pool can also describe the intersection of orders that create price levels which, after reaching a certain threshold, can see the asset decide whether to follow the trend upward or downward.
DEXs that leverage liquidity pools typically also rely on automated market maker systems. Such trading platforms use pre-funded on-chain liquidity pools for the assets involved in trading pairs rather than utilizing the usual order books.
By using liquidity pools, exchange platforms do not require the traders to decide on a given trading price for the assets. Instead, the platforms leverage the liquidity pool with the locked-in assets. Trades can occur with limited slippage regardless of the illiquidity levels of the trading pairs as long as the liquidity pool has sufficient funds.
Users providing the funds for liquidity pools can earn a passive income on their deposits via trading fees. The income is calculated based on the percentage of their contribution to the liquidity pool. Tokens that confirm a user's contribution to a liquidity pool are called "LP tokens". Users can usually withdraw their assets from liquidity pools at any time, unless there's a lockup period.
Bancor, an Ethereum-based trading platform, was among the first to implement liquidity pools for its trading. This system has since become widely used, particularly thanks to the popularity of the Uniswap exchange platform.
Note that, in liquidity pools, price changes in paired tokens might lead to potential losses. This is called an "impermanent loss". Potential factors that can influence these price changes range from supply & demand, all the way to trading volume, external market prices, or even other users participating in arbitrage.