Beginner's guide to Liquidity Pools

Updated on 19 August, 2022 3:28 PM
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    A digital collection of cryptocurrencies locked in a smart contract is referred to as a liquidity pool. As a result, liquidity is created, allowing for quicker transactions.

    A liquidity pool's automated market makers (AMMs) are a key component. In contrast to traditional trading through a market of buyers and sellers, an AMM is a system that uses liquidity pools to facilitate automated trading of digital assets. In other words, the price of the tokens in a liquidity pool is determined by an internal mathematical formula used by an AMM platform, which users of the platform contribute tokens to. Additionally, yield farming and blockchain-based online games also require liquidity pools.

    Importance of Liquidity Pools

    The purpose of liquidity pools is to reward users of various cryptocurrency platforms (LPs). After some time has passed, LPs receive liquid provider tokens (LPTs), which are a portion of the fees and rewards corresponding to the amount of liquidity they provided. Then, there are various uses for LP tokens on a DeFi network.

    By offering incentives to its users and offering liquidity in exchange for a cut of trading fees, the liquidity pool seeks to solve the problems associated with illiquid markets and slippage costs. It is not necessary for trades performed through liquidity pool software like Uniswap to match the expected price and the executed price. AMMs are designed to efficiently enable trades by bridging the gap between buyers and sellers of crypto tokens, making trades on DEX exchanges simple and dependable.

    Some common DeFi exchanges like SushiSwap (SUSHI) and Uniswap leverage liquidity pools on the Ethereum network using ERC-20 tokens. PancakeSwap utilises BEP-20 tokens on the BNB Chain.

    How do Liquidity Pools Work?

    The bulk of liquidity providers are compensated by the exchanges where they pool tokens in the form of trading commissions and cryptocurrency rewards. When users contribute liquidity to a pool, they are typically compensated with liquidity provider (LP) tokens. Within the DeFi ecosystem, LP tokens have a number of uses and can be valuable assets on their own.

    Liquidity pools can maintain fair market prices for the tokens they hold thanks to AMM algorithms, which keep token prices in relation to one another within any given pool. 

    Liquidity Pools in Yield Farming

    Liquidity mining is the process of joining the incentive-driven liquidity pools as a provider to obtain the most LP tokens possible. In order to maximise their LP token earnings on a specific market or platform, crypto exchange liquidity providers use liquidity mining.

    In order to generate tokenized rewards, the yield farming technique entails staking or locking up digital assets within a blockchain system. The technique of "yield farming" is staking or locking up tokens in a number of DeFi apps in order to offer tokenized rewards that boost revenue. A crypto exchange liquidity provider can achieve big returns at a somewhat higher risk since their assets are allocated to trading pairs and incentive pools with the highest trading fees and LP token rewards across numerous platforms. With this kind of liquidity investing, a user's money may be automatically invested in the asset pairs with the highest yields. 


    One of the key technologies in the current DeFi technology stack is liquidity pools. They permit, among other things, decentralised lending, trading, and yield production. Almost all aspects of DeFi are currently powered by smart contracts, and this trend is likely to continue in the future. 

    A good way to earn money passively with cryptocurrencies is through liquidity pools. To guarantee a consistent and secure income, the first step is to select a reliable platform and the best pools. 

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