Liquidity Pools
Liquidity pools, not to be confused with pools filled with water but rather pools filled with money. They are smart contracts that allow traders to trade tokens and coins even if there are no buyers or sellers out there.
Traditional Stock Markets use a model wherein buyers and sellers put down their orders and submit how much of a stock they want to buy and at what price they want to buy it. Then a trade only happens when two buyers and sellers meet at the same price. The buyer gets the stock and the seller gets the money. Buying a stock at market price, you are essentially submitting an order to buy all the stocks that you want at the price sellers are currently willing to sell them for. This is an inefficient way of buying or selling because you have to set a price that someone else is willing to buy or sell at. You’ll hope that eventually someone comes along that matches the price that you are looking for.
Enter the Liquidity Pool that uses an algorithm so that you will always be able to buy or sell an asset no matter what the price is, and no matter if there is a buyer or seller to meet your current needs. A liquidity pool is a pool of money that contains both assets of what you are willing to trade for. Liquidity pools are just code in the form of a smart contract written in a way that it can contain funds, do calculations with those funds and allows you to trade based on the calculations that it did. Most liquidity pools use an algorithm called a Constant Product Automated Market Maker. Remember that the more you buy a certain token by giving it more of another token, it will slowly raise the price of that token. The technical term for this is Routing. The decentralized exchange will route some trades for you so that you can essentially trade any token on their platform for any other token, even if there aren’t a bunch of liquidity pools for that token.
In liquidity pools, for you to make a trade, every transaction has a tax that will cost a very small percentage of each trade. The more money that is in a liquidity pool, the more stable the price is and it can sometimes have up to millions worth of assets. Price Impact is how much your buying from the liquidity pool affects the price. If the pool is small, you will affect the price a lot and can even easily double or triple the price of an asset. However, in a large pool, your price impact is small and large buyins affect the price less.
Liquidity pools reward investors. The investors are the people who put up the money to the liquidity pool in the first place. Whenever you put money into a liquidity pool, you are what is called a liquidity provider. The investors are given a small fraction of each trade that happens. Even if this is less than 1 % of each trade but if someone is trading multiple times a day, those numbers really add up to substantial amounts and are profitable for the investor.
One more thing about the power of liquidity pools, they can get complicated very quickly. For example, Balancer is a platform that allows up to eight assets in one liquidity pool. The calculations and the algorithm on that is complicated, but it does show the limitless potential of decentralized finance.