What are Liquidity Pools?


With the explosion of DeFi projects comes new ways of managing, handling, and storing money. One method that decentralized tools use to do this is via liquidity pools. These are a revolutionary and deeply significant technology that has allowed for DeFi to flourish over the last few years.


Introduction to Liquidity Pools


Liquidity pools are relatively new tech, being popularised by Uniswap; perhaps the most famous decentralized exchange on the market. Essentially liquidity pools are smart contracts that hold large quantities of funds within one location, that allow traders or borrowers to take from that pool. They help decentralized exchanges and loan providers to connect individuals with the money they are looking to work with.


People hand their coins and tokens over to liquidity pools in exchange for an incentive of some sort (with different projects offering different incentives). These funds are then used to help make trades or issue loans. The money people hand is not exactly lost, because a fully functioning liquidity pool should never run out of its funds, and so the people giving their money over should be able to take their money out in the future.


Liquidity pools were developed as a way of helping to bootstrap DeFi lending and trading platforms in their early stages; when DeFi was in its infancy, there were few people using them because they were new and untested. This meant that if traditional order books were used then people would have to wait hours, or even days, for their trades to be matched with another person. However, liquidity pools eradicate this issue because rather than being matched with another person, users are instead matched with the project itself, which is always ready to issue a loan or make a trade because it always connects to the liquidity pool. These are known as automated market makers (AMM)


What are AMMs?


An AMM is a machine or program that matches with every trader or borrower. They automatically match each person with the best offer for the token or coin they are about to engage with. They are the ultimate alternative to the traditional order book, because AMMs are always available and can be used by multiple people, so they are perfect for newer projects that might have a low user-count.


AMMs use algorithmic principles to adjust their prices in accordance with the standards of the market at large, meaning that competitive rates are consistently offered. For the end user, there is no noticeable difference between engaging with an automated market maker and a real human.


Downsides of Liquidity Pools


Liquidity pools and automated market makers are necessary inventions within the DeFi market, but like all DeFi inventions, they are not always stress-tested or foolproof. One of the biggest downsides of using a project that has a liquidity pool is that the pool can get hacked. It is rare, but as DeFi is all based around programming (rather than human intervention) it is entirely possible for somebody to break into a liquidity pool and deplete it. Generally, this will not cause issues with the end user, so long as they are borrowing or trading, and not holding their money in the pool. In these circumstances, all that would happen is that the pool would close down.