#Liquidity101 What Are Liquidity Pools?
Liquidity pools enable users to buy and sell crypto on decentralized exchanges and other DeFi platforms without the need for centralized market makers.
A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (DEX). Instead of traditional markets of buyers and sellers, many decentralized finance (DeFi) platforms use automated market makers (AMMs), which allow digital assets to be traded in an automatic and permissionless manner through the use of liquidity pools.
The Role of Crypto Liquidity Pools in DeFi
Crypto liquidity pools play an essential role in the decentralized finance (DeFi) ecosystem — in particular when it comes to decentralized exchanges (DEXs). Liquidity pools are a mechanism by which users can pool their assets in a DEX’s smart contracts to provide asset liquidity for traders to swap between currencies. Liquidity pools provide much-needed liquidity, speed, and convenience to the DeFi ecosystem.
Before automated market makers (AMMs) came into play, crypto market liquidity was a challenge for DEXs on Ethereum. At that time, DEXs were a new technology with a complicated interface and the number of buyers and sellers was small, so it was difficult to find enough people willing to trade on a regular basis. AMMs fix this problem of limited liquidity by creating liquidity pools and offering liquidity providers the incentive to supply these pools with assets, all without the need for third-party middlemen. The more assets in a pool and the more liquidity the pool has, the easier trading becomes on decentralized exchanges, regardless of fluctuations in Ethereum's price, which can influence trading volume and pool activity.
Why Are Crypto Liquidity Pools Important?
Any seasoned trader in traditional or crypto markets can tell you about the potential downsides of entering a market with little liquidity. Whether it’s a low cap cryptocurrency or penny stock, slippage will be a concern.
