by Hodler Ash 
It’s impossible to be a trader in the crypto community without coming across liquidity pools. However, if you are a newbie, here’s your chance to understand what liquidity pools are before you begin buying and selling properly. Liquidity pools allow traders to invest their cryptos via DeFi platforms and decentralized exchanges without a centralized body. So, in a nutshell, from the name liquidity pool, it’s a crowdfunding pool of cryptocurrencies locked using a smart contract to facilitate trades on DEXs. Automated Market Makers (AMMs) are used for trading cryptos on the DeFi platform, permissionless and automatic.
What do liquidity pools do on DeFi platforms?
The crypto liquidity pool is an essential component of the DeFi world, especially on DEXs. Liquidity pool is a channel through which investors could bring in their assets and contribute to the DEXs smart contracts to provide means for smooth transactions such as swapping of cryptos, buying, and selling of holdings. There’s room for more convenience and speed in the DeFi crypto community with liquidity pools. Before the evolution of the AMMs, liquidity pool was tasking for investors on the Ethereum blockchain. There were few buyers and sellers during this time, and DEXs did not have such an enticing interface, as they were a new technology. So, getting sufficient traders daily was somewhat tasking. With the introduction of AMMs, liquidity providers were given incentives as a means of paying back their risks. Hence, the more liquidity an asset has, the easier it becomes to trade such crypto on DeFi platforms.
How does the liquidity pool work?
It allows liquidity providers to easily provide liquidity with incentives, which helps investors to stake even more. This is one of those reasons why liquidity providers often earn trading fees and crypto rewards on their DEX. So, most times, when an individual provides liquidity, he gets liquidity provider tokens, and these assets could be valuable in their own right as they are usually used on DeFi platforms.
The proportion of LP tokens received is primarily according to the amount of liquidity provided. So that when the pool carries out any trade, a fraction of the fee is distributed across all the LP providers. For the liquidity provider to get the liquidity they have initially provided, their LP tokens need to be destroyed. Thanks to AMMs’ algorithm that maintains the price of tokens, liquidity pools maintain market value for the tokens they hold. Note that liquidity pools algorithms may differ depending on the protocols.
What are the benefits of liquidity pools?
As explained earlier, the liquidity pool is slightly different from the actual buying and selling of cryptocurrency. In this case, you are lending your tokens to the DEX for a specific period, with the aim of getting incentives (LP tokens). Here are some of the benefits of adding liquidity on a DEX.
You build exchanges, not make trades
With LP, you don’t have to convince the other person to see cryptocurrency the same way you see crypto. Liquidity pools’ structure the value of cryptocurrencies following the platforms’ exchange rate. So, you need not worry about selling high and buying low. Users don’t get assets by trading on exchange platforms; instead, they get pre-funded liquidity.
Market impacts are minimal
Since no users are exercising FOMO or sellers demanding buyers to pay double the market price, transactions become lots smoother and more manageable. This reduced the forces of market impacts on the growth of such cryptocurrency. Since the liquidity pool encompasses funds locked via smart contracts, their values only get updated depending on the exchange rate. Hence, there are little or no external force impacts on price.
What you contribute is what you get
Another exciting benefit of the liquidity pool is that you need not worry about your LP tokens. Since the amount of incentives you get would depend on the amount of liquidity supplied, you only need to make sure you provide as much liquidity as possible to the pool to have significant LP tokens by the time the reward starts. Most LP providers are not regular crypto traders, and some are investors that only invest in liquidity pools on DEXs. They are regarded as the fuel that keeps the fire burning. What you give is what you get. If you supply more liquidity, you will get more LP rewards. So, if you have been keeping your crypto dormant, you should probably invest in liquidity pools as they are very valuable especially during bull runs.
