Understanding Liquidity Pools
A liquidity pool is a collection of tokens that are locked in smart contracts. These pools aim to address the issue of illiquidity in decentralized exchanges. Liquidity pools also determine price levels that influence the movement of assets.
Liquidity pools are primarily used by decentralized exchanges that rely on automated market maker (AMM) systems. These platforms replace the traditional order book with on-chain liquidity pools that are pre-funded for each trading pair.
The main advantage of liquidity pools is that they eliminate the need for buyers and sellers to agree on a specific price for exchanging assets. Instead, they use pre-funded liquidity pools, allowing trades to occur with minimal slippage, even for illiquid trading pairs, as long as there is a sufficiently large liquidity pool.
Users who contribute funds to liquidity pools, called liquidity providers, also earn passive income through trading fees. These fees are based on the percentage of the liquidity pool they provide.
The concept of liquidity pools was first introduced by Bancor, an Ethereum-based trading system. However, it became widely adopted in the cryptocurrency space after Uniswap popularized it.
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