How do liquidity pools work?

If you have not heard of a liquidity pool, then you haven't encountered the concept of decentralized finance. Picture in your mind a world with no banking system and other intermediaries, but a place built on blockchain networks, consisting of smart contracts and, of course, cryptocurrencies.

This is DeFi. Such a global financial system should have liquidity. For this reason, liquidity pool is a fundamental concept in this kind of ecosystem.

A liquidity pool is a specific digital container with cryptocurrency funds based on blockchain. What is the role of smart contracts? The funds of investors can be locked in smart contracts. The advent of liquidity pools has made it easier to use assets for farming, trading, lending, and earning.

On decentralized exchanges’ pools, users supply liquidity and withdraw it. A liquidity provider forms a pool by attaching two assets. So he sets an initial exchange rate. All users of the market can make conversions inside his pool for a fixed fee. Asset swaps increase or decrease the volume of represented assets thus changing the volume and price of each asset in the pool. The larger the liquidity pool is, the more stable is the price of each asset in it. Any user can become a provider and obtain rewards for liquidity being locked. Reward size is determined by the provider's share in the pool.

A lot of providers can deliver a lot of liquidity. And, as we know, liquidity always attracts even more liquidity. This is what happened with Uniswap, which has become a very popular decentralized exchange in DeFi space. The profitability of the pool is determined by transaction activity inside it.

There are several main risks for liquidity providers that must be considered, including impermanent loss, the risk of developers changing the rules in the project, and, of course, the risk of smart contracts. This is important to understand.

The popularity of liquidity pools gives impetus for improvement. Creating a pool with more than two tokens or a pool with stablecoins, generating returns by yield farming, governance votes for protocol management, insurance of most common DeFi risks - all of it has become possible.

Liquidity pools have created a good name for many DEXes and DeFi in general.