Millions of transactions occur on crypto exchanges every day each transaction is carried out at a fast rate. If you have ever wondered where these cryptocurrencies come from, and how they are readily available for buying and selling in the crypto market, then keep reading. 

These questions bring you closer to knowing the meaning of market liquidity pools. Especially for decentralized exchanges, liquidity pools play a very important role. Without them, a DEX won’t be able to survive. 

So in this article, we will provide you with substantial knowledge on the meaning of liquidity pools, how it works, and their importance to the crypto industry. 

What Are Market Liquidity Pools?

Liquidity pools are smart contracts containing a massive amount of cryptocurrencies and assets locked up to provide liquidity for a decentralized crypto exchange. 

Since decentralized exchanges receive a huge amount of transactions daily, they need an equally large amount of liquidity to keep running. 

Here, liquidity providers lock up digital assets, and crypto exchanges can use these locked-up assets to facilitate the buying and selling of cryptocurrencies. Liquidity pools work with the help of automated market makers (AMMs), and it helps connect buyers and sellers. 

How Do Liquidity Pools Work?

Source: Cryptorobin

Have you ever gone to a shopping mall with many customers and only one cashier? Immediately, you are worried about how long you will stay to make a transaction at the mall because of the small number of cashiers compared to customers. In such a situation, transactions are slow, and you would have to wait for a really long time before it reaches your turn. 

But transactions are faster if you enter a shopping mall with large customers but an equally large number of cashiers. 

Liquidity pools are mainly used in the decentralized finance sector, and it ensures transactions go at a faster rate. To become a liquidity provider for a decentralized crypto exchange and earn rewards, you must follow some steps. 

• The first thing you need to do is to purchase the cryptocurrency that you want to lock up in a liquidity pool. Assuming you want to lock Ethereum in a liquidity pool, you should purchase the amount you want to be locked up. 
• Then create an account with the decentralized exchange and transfer the cryptocurrencies to the account. 
• You need to find your preferred trading pairs and deposit equal funds into the trading pairs. For instance, if you have $2,000 to invest and choose ETH and USDT as your trading pairs, you would deposit $1,000 each. 
• Once you have made the deposits, you can select your lockup period and wait for it to elapse. 

The Importance of Liquidity Pools

Source: Leewayhertz

Liquidity pools are extremely important for the DeFi ecosystem, as the sector would be so stagnant without liquidity pools. When you go to decentralized exchanges, you notice how fast transactions are due to this process. 

The story would have been different, assuming there was no liquidity pool. Without liquidity pools, you would have waited for hours or even days before your transaction went through. 

Let’s say you want to buy some cryptocurrencies using the P2P method; the seller controls the price. However, on decentralized exchanges, the AMMs provide you with the current price of assets in the parallel market. 

Benefits Of Liquidity Pools

Fair Market Price 

The price offered for exchanges in liquidity pools is fairly transparent and based on exactly what is happening in the market. This is because AMMs generate the price shown by liquidity pools, and it has a clear knowledge of the market outlook. Since other traders do not determine the price of assets as compared to P2P exchanges, it makes things fair on liquidity pools. 

Faster Transaction 

One of the major benefits that the crypto market gets from liquidity pools is that it makes transactions much faster than before. Instead of waiting for many hours to buy or sell cryptocurrencies, it just happens within minutes or sometimes seconds. 

Since the crypto you wish to buy and sell is already available in the liquidity pool, you only need to make a transaction, and the crypto will immediately be transferred to your wallet. Compared to other categories of exchanges, such as centralized and P2P, DeFi has an edge here. 

Secured 

The mechanics used in setting up liquidity pools are secured, making the whole transaction process secure. The AMMs involved in decentralized exchanges use smart contracts to identify sellers and buyers within seconds in an exchange and initiate a transaction. 

The fast time frame and the smart contract’s complexity make it incredibly hard for anyone to go against the transaction terms. Once you initiate a transaction, the seller or buyer can’t pull out of it. 

More Rewards 

Compared to other categories of exchanges, DeFi provides more rewards to its users due to liquidity pools. Centralized exchanges often use non-automated market makers to provide liquidity. These market makers are often large corporations that have large amounts of crypto assets in their possession.

This is entirely different when it comes to decentralized exchanges. Since almost all their liquidity comes from liquidity pools, anyone that has some amount of crypto asset can participate in the liquidity pool. And in virtually all cases, you are rewarded for locking your funds up and providing liquidity for the exchange. 

Challenges Faced By Liquidity Pools

Price Change 

Since decentralized exchanges use AMMs on their liquidity pools, their price constantly changes. It is not manually done, so the price change can be so fast that you may make losses by buying and selling cryptocurrencies. 

Scammy Liquidity Pools 

You should be very careful of the decentralized exchange to which you pool your assets. There are scam exchanges out there whose developers have access to the smart contract code and use it to defraud users of their assets. You should carefully evaluate a decentralized exchange before making transactions or contributing to its liquidity pools. 

Final Thoughts

Liquidity pools serve a very important role in the crypto industry as it helps facilitate the trading of cryptocurrencies in decentralized exchanges. Due to the large volume of transactions happening in DEXs, liquidity pools help provide the assets needed for buying and selling cryptocurrencies. 

Liquidity pools serve many benefits as it helps make trading faster, the whole process is transparent, and it is fairly secure. But you need to be very careful as scams can occur too, and there can be price changes that can result in losses.

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