Liquidity is important in financial and crypto markets as it measures how quickly an asset is converted to cash and avoids drastic price movements.
What about liquidity pools that are said to play an important role in creating liquidity in the decentralized financial system (DeFi)?
A liquidity pool is a digital stack of cryptocurrencies locked in a smart contract, thereby generating liquidity to make transactions faster. Automated market makers (AMMs) are a key component of the liquidity pool.
AMM is a protocol that uses liquidity pools to allow digital assets to be traded automatically rather than traditional markets that require buyers and sellers.
In other words, users of the AMM platform are provided with liquidity pools together with their tokens, including the price of the tokens in the pool will be determined in AMM's own mathematical formula.
Liquidity pools are essential for yield farming and blockchain-based online games and are designed to incentivize users of different crypto platforms called liquidity providers (LP).
LP will be rewarded through a small portion of fees and incentives which is equivalent to the amount of liquidity it provides.
One of the DeFi exchanges using liquidity pools on the Ethereum network containing ERC-20 tokens is SushiSwap (SUSHI) and Uniswap, while PancakeSwap uses BEP-20 tokens in the BNB Chain.
The main goal of liquidity pools is to eliminate the issue of the illiquid market, which is the situation of difficulty in liquidating assets due to several factors including the lack of buyers.
Therefore, liquidity pools have provided incentives to their users as well as providing a search for a portion of trading fees.
In the meantime, trading with a liquidity pool program such as Uniswap does not require the expectation of price matching and execution.
AMM is programmed to facilitate trading by eliminating the gap between buyers and sellers of cryptocurrency tokens.
Among the advantages of liquidity pools is that it can facilitate DEX trading in doing transactions at the current market price and allow users to provide liquidity and receive rewards including interest or annual percentage of revenue on their cryptocurrency.
Liquidity pools also use publicly viewable smart contracts to ensure the security of audit information.
While the lack of liquidity pools is a group of funds under a small group which is against the concept of decentralization.
In addition, hacking exploits due to weak security protocols will cause losses to liquidity providers, including fraud such as rug pulls and scammers.
