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The role of liquidity pools in DeFi

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The liquidity pools operating in the DeFi sector play a very crucial role in decentralised exchanges on the blockchain. These pools act as a mechanism in the market through which various users can quickly pool their assets in a DEX smart contract. These smart contracts directly provide liquidity to traders who use it to swap between various currencies and convenience in the entire DeFi ecosystem.

The liquidity pools is a pool of crowdsourced cryptocurrencies wherein the tokens are locked in a smart contract which is further used to facilitate a trade between various assets present on the decentralised exchange. These DeFi platforms however do not depend on a traditional market of buyers and sellers in order to trade these assets instead they use automated market makers which permit users to trade digital assets in an automatic and a permissionless manner without the necessity of any regulatory standards.

Prior to the ideation of Automated market makers the liquidity of crypto markets was a massive challenge for the decentralised exchanges operating on the Ethereum network. During its inception the Decentralised exchange technology was very foreign to the markets therefore the total number of buyers and sellers on such platforms were very low.

The new technology paired with a complicated interface didn’t interest new buyers and sellers into joining the network thus these platforms had very low users on it’s network. Inorder to solve this problem Automated Market makers innovated this issue with the help of liquidity pools. The AMM created various liquidity pools in the market wherein the entities which provided liquidity were directly incentivised by allowing them to supply these pools with their assets. This entire process would be executed without a trace of any middlemen. The metric for liquidity pools became as a simple as higher the liquidity directly translates to higher assets in the liquidity pool.

These liquidity pools solve a very crucial problem in the cryptocurrency ecosystem ie. Liquidity. If a trade is entered into a market with very low liquidity there are chances of slippage. The slippage is the difference between the expected price of any specific trade and the price at which it had to be executed. Slippage is very high in volatile market conditions therefore liquidity pools solve this problem by providing liquidity to the asset.

The process works in a manner wherein the problem of markets with low liquidity is solved by giving incentives to users wherein they can provide themselves some liquidity in lieu of trading fees. In layman terms the idea executes itself in a manner wherein the users can execute an exchange by simply exchanging the tokens by using the liquidity which is provided by the users and the transaction works through a smart contract.