What is a Liquidity Pool?

An overview of Automated Market Markers & Liquidity Pools

Liquidity pools are an innovative solution within DeFi to create the mechanics of a market maker in a decentralised fashion. Although often met with confusion, they are simply clusters of tokens with pre-determined weights. A token's weight is how much its value accounts for the total value within the pool. Liquidity Pools are an exciting and equalising tool, which represent the true nature of the Decentralised Finance (DeFi) and Web3.0 movement.

This blog will offer some insight into Liquidity Pools.

Understanding the origination of Automated Market Makers (AMMs) and Liquidity Pools

Here we’ll explain what a liquidity pool is and why they are needed in decentralised finance (DeFi) but first, like many things in the Web 3.0 and DeFi space, it’s important to understand the existing world of trade finance.

Traditional exchanges, i.e. Nasdaq, London Stock Exchange, STAR, work through an order book model which records the average of the current bid and ask prices being quoted. In this model buyers and sellers come together to trade; buyers simply try to buy at the lowest price possible, and sellers try to sell for the highest price.

For a trade to be completed both parties must agree on a fair price meaning either the buyer comes up or the seller goes down. However, it’s not that simple because finding someone who wants to both buy that specific amount and for the price they are looking to sell for is unlikely.

Let’s use an example.

A basket of apples

Photo credit: Skånska Matupplevelser

You’ve just picked 100 apples on a farm but suddenly you have to leave town and need to sell every single one of them. You have to sell them at the market price of $1 in order to have enough to pay the farm their fee. You can’t find anyone willing to pay at this price and you can’t take them with you. You’re stuck. This is where market makers come in handy.

In this example, the market maker would be an individual or company who is permanently on hand to purchase the apples at the market price of $1. When you place a market order to sell your apples, the market maker will buy them from you even if it doesn’t have a buyer lined up. Likewise, the reverse is also true; a buyer can purchase the apples even if a seller isn’t lined up.

Market makers in return earn a profit through the spread between the bid and offer price as they bear the risk of covering the apple which may drop below the market price. Without them, it would take considerably longer for buyers and sellers to be matched up, which in turn would reduce liquidity, making it more difficult to enter or exit positions (or leave town). They also track the current price of assets by changing their prices — hence they ‘make’ the market. This is the same method that Centralised Exchanges, such as Coinbase and Binance, work, however, it is not truly decentralised whilst you have a market maker acting as an intermediary to exchange.

That said, although it is valuable to buyers and sellers alike, as market makers perform this delicate balancing act, they command a disproportionate amount of power over the market and ultimately act as an intermediary… a big no in the decentralised vision.

Enter AMMs and liquidity pools

Where traditional finance requires expensive and centralised intermediaries which have a level of power to manipulate prices, AMMs allow digital assets to be traded in a permissionless and automatic way.

This both embodies the ideals of blockchain and decentralisation generally and offers users and companies unique opportunities to trade more efficiently and cheaply whilst having total trust in the system makes it so. Before they arrived on the scene, liquidity, i.e. how easy it is for one asset to be converted into another, often fiat currency without affecting its market price, was difficult for DEXs.

AMMs offer a solution to scarce liquidity through liquidity pools; a shared pot of tokens that users can trade against. Users can create a liquidity pool and others can supply tokens to it. In return, like with traditional market makers, those that are willing to take on the risk of providing liquidity to the pool earn fees and other rewards. An explanation specific to Osmosis can be found here. At the time of writing Osmosis’ liquidity pools contain about $544 million in total value locked (TVL).