Liquidity is a fundamental part of both the crypto and financial markets. It is the manner in which assets are converted to cash quickly and efficiently, avoiding drastic price swings. If an asset is illiquid, it takes a long time before it is converted to cash. You could also face slippage, which is the difference in the price you wanted to sell an asset for vs. the price it actually sold for.
Liquidity pools play a large part in creating a liquid decentralized finance (DeFi) system.
Imagine waiting to order inside a fast-food restaurant. Liquidity is comparable to having lots of cashiers. That would speed up orders and transactions, making customers happy. On the other hand, illiquidity is comparable to having only one cashier with a long line of customers. That would lead to slower orders and slower transactions, creating unhappy customers.
How do liquidity pools work?
A liquidity pool is a smart contract where tokens are locked for the purpose of providing liquidity. Some of the important concepts required to understand how liquidity pools and decentralised exchanges work include liquidity providers, liquidity tokens and automated market makers.
Liquidity pools are used not only by decentralised exchanges to swap tokens, but also for borrowing and lending activities. As such, they play an important role in the DeFi ecosystem.
What is the purpose of a liquidity pool?
In a trade, traders or investors can encounter a difference between the expected price and the executed price. That is common in both traditional and crypto markets. The liquidity pool aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.
Trades with liquidity pool programs like Uniswap don't require matching the expected price and the executed price. AMMs, which are programmed to facilitate trades efficiently by eliminating the gap between the buyers and sellers of crypto tokens, make trades on DEX markets easy and reliable.