A liquidity pool is a supply of cryptocurrencies or tokens locked in a smart contract in order to keep a decentralized exchange (DEX) liquid for trades to be executed. Liquidity pools allow users to pool their assets in a DEX’s smart contract to provide liquidity for traders to swap between currencies.
Liquidity pools facilitate speed, and convenience to the DeFi ecosystem like decentralized trading, lending, borrowing and other DeFi activities. Liquidity pools are the foundation of many decentralized exchanges (DEX), such as Uniswap and Pancakeswap.
Those who provide assets are called liquidity providers (LP). They add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, according to the ratio of liquidity they provide.
When DEXs started out, it was difficult to find enough people willing to trade on a regular basis. AMMs solve this problem of insufficient liquidity by creating liquidity pools and enabling liquidity providers to supply these pools with assets without a 3rd party.
How do DeFi liquidity pools work?
A single liquidity pool typically holds 2 tokens and each pool creates a new market for that particular pair of tokens. DAI/ETH is a good example of a popular liquidity pool on a DEX like Uniswap.
A liquidity pool must be built in such a way that rewards crypto liquidity providers who stake their assets in a pool. Hence, most liquidity providers earn trading fees and crypto rewards from the DEXs they provide liquidity for. When a user stakes their assets in a liquidity pool, such user is often rewarded with liquidity provider (LP) tokens.
LP tokens are assets that can be used throughout the DeFi ecosystem in various degrees. The LP tokens a user gets is according to the amount of liquidity they have supplied to the pool. When a pool facilitates a trade, the trading fee is proportionally shared amongst the LP token holders.
If a liquidity provider intends to get back the liquidity they provided in addition to accrued fees from their portion, their LP tokens must be burned.