What is a liquidity pool? (Part 1) The emergence of liquidity pools and noun analysis

Decentralized finance is a more democratized version of our current financial system that will mature in a few years, making people more independent and accountable when using their digital currencies. In 2020-2021, several DeFi projects launched in the cryptocurrency universe, and some of these exciting DeFi concepts are collectively powering our DeFi ecosystem.

Decentralized Finance or DeFi is a digital revolution that utilizes a decentralized network, operating without any third party custodian or intermediary, to transform our old and near-collapse financial system into trustless and transparent agreement.


Some of the core concepts driving the prosperity of this DeFi world include Liquidity Pools. So today we will take a look at what a liquidity pool is.

1. The emergence of liquidity pools

Before we explain how a liquidity pool works in it, let’s first understand why it is needed?

LIQUIDITY POOL refers to a pool of tokens locked in smart contracts. They facilitate transactions by providing liquidity. These liquidity pools will be used by decentralized exchanges (DEXs). The earliest adoption of liquidity pools was Bancor, but it was Uniswap that really made it popular.

If you are familiar with exchanges like Coinbase or Binance, you will know that trading there is based on an order book model. It’s the same as traditional stock markets, like the NYSE and the Nasdaq.

In these order book model marketplaces, buyers and sellers each place their orders. Buyers (also known as BIDDERS, bidders) expect to buy the desired asset at the lowest price, while sellers expect to sell the same asset at the highest price.

Therefore, for the transaction to be established, the buyer and the seller must reach a consensus on the price. A transaction can happen in two situations, one is when the buyer raises the bid price, and the other is when the seller lowers the price to sell.

But what if no one is willing to re-bid? Or what if the amount of coins you want to buy is not enough?

At this time, we must rely on the participation of market makers. Simply put, a market maker is an entity that facilitates transactions, and it will always accept buy and sell orders to provide liquidity. Therefore, users can trade without waiting for the counterparty to appear.

But DeFi does finance in a decentralized scenario, how to build this market maker? At this time, there is no centralized role, so the concept of liquidity pool needs to be introduced.

2. Conceptual explanation of liquidity pool

What does liquidity mean? It means you can trade when you want to.

The meaning of liquidity pool is actually very simple, that is, two different currencies (or commodities) are placed in a pool, so that you can trade when you want to trade. This pool is actually called an automatic market maker (AMM), which can automatically make this market for you, and trade if you want to trade 7*24 hours a day. These two coins form a trading pair. When you want to trade, just take the coins you want from this pool and throw the coins you paid into it.

Case description: For example, there is now a liquidity pool with 100 ethers in it, assuming that each ether is worth $100 now, and the value of ether is $10,000; there are also 10,000 USDT in it, which are also worth $10,000, totaling The pool’s funds add up to $20,000. This pool can provide liquidity. The value ratio of Ether and USDT in the pool is 1:1, which can be exchanged for both Ether and USDT, which is wonderful. Generally speaking, the initial value ratio of the liquidity pool is 1:1.

In fact, the liquidity pool has many advantages, such as guaranteed liquidity at each price level. In short, investors do not need to establish direct connections with other investors, because as long as customers invest their own assets into the asset pool, liquidity In addition, automatic pricing can realize passive market making, which means that liquidity investors actually deposit their funds into the fund pool, and smart contracts are responsible for pricing, so the liquidity pool provides users and exchanges with easy-to-use On the platform, users do not have to meet any special eligibility criteria to participate in the liquidity pool, which means that anyone can participate in the liquidity provision of token pairs.


In the next issue, we will introduce the technical basis of the liquidity pool in detail.

*The content of this article does not constitute any investment transaction advice.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/what-is-a-liquidity-pool-part-1-the-emergence-of-liquidity-pools-and-noun-analysis/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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