We previously shared the differences between centralised exchanges (CEX) and decentralised exchanges (DEX) here. Today, let us focus on the enabler for DEXs to function — liquidity pools.
Liquidity pools are a collection of token pairs that are locked in a smart contract and hosted on a blockchain network.
These pools of tokens provide liquidity for decentralised trading, lending, payments and other decentralised finance (DeFi) use cases to occur.
Liquidity pools are created by liquidity providers (LPs) that contribute an equal value of token pair and create a pool of funds to create a market.
For example, the price of ETH can be equal to 1,000 USDC. Liquidity providers contribute an equal value of ETH and USDC to the pool, so someone depositing 1 ETH would have to match it with 1,000 USDC.
In return, LPs earn trading fees from trades that take place in their pool, in proportion to their share of total liquidity.
Liquidity pools play an important role in DEXs as it allows for the decentralisation of transactions to occur. On CEXs, orders are handled through an order book which requires both buyer and seller to agree to the transaction.
Should both parties not agree on a price for the trade, market makers come into the picture to facilitate trading by playing both the role of a buyer and seller to enable the transaction to go ahead.
On DEXs, liquidity pools act as automatic market makers that allow trading to occur without requiring a mutual agreement from both buyers and sellers.
When a user executes a trade on a DEX, they are trading against liquidity in the pool.
Therefore, for a buyer to trade a token, there is no need for a seller to be simultaneously present, just sufficient liquidity in the pool.
The prices are also therefore determined by the supply and demand of the tokens within the liquidity pool.
For example, if you are trading ETH for USDT, the pool of ETH within the liquidity pool you’re trading on would increase.
The opposite occurs for USDT. Hence, depending on the size of the trade, there would be price changes for the respective tokens — price decreases for ETH since supply increases; increase in price for USDT since supply decreases.
As trading occurs on the liquidity pool, LPs are subjected to impermanent loss, resulting from volatility due to trading within the liquidity pool.
Besides, as these liquidity pools are built upon smart contracts, bugs or flash loans within one could make them susceptible to attacks, which could result in total loss of funds for LPs.
In conclusion, liquidity pools form the backbone of DEXs. It is the presence of one which enables the decentralised nature of DEXs to occur. By enabling trades to occur asynchronously, it is fuelling the growth of decentralised finance (DeFi).
Furthermore, the blockchain networks on which liquidity pools are hosted provide an additional layer of security, enabling both traders and LPs to transact securely.
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