What are Liquidity pools?

The cryptocurrency market is a very active community that initiates thousands of transactions to be verified daily, but verifying transactions can be pretty slow.

Crypto liquidity pools provide a faster means of turning digital assets into cash, and this option can be helpful for people who make frequent transactions.

This article will inform you about liquidity pools, how they work, and several other things you should know about them.

What is a liquidity pool?

A liquidity pool is a smart contract containing large portions of cryptocurrency, digital assets, tokens, or virtual coins locked up and ready to provide essential liquidity for networks that facilitate decentralized trading.

A decentralized exchange relies greatly on liquidity because of the regular rate at which transactions are made on their network; for this reason, decentralized exchanges need to be connected to liquidity pools that can help maintain a steady functional network that doesn’t delay transactions made by traders.

In crypto liquidity pools, digital assets are locked and ready for exchange. Liquidity pools serve as a digital asset reserve that can provide liquidity to help speed up transactions for decentralized finance (also known as DeFi) markets such as decentralized exchanges (also known as DEX).

Unlike traditional finance, which pairs buyers and sellers to complete a transaction, liquidity pools do not need to connect users to complete a trade. Instead, they function automatically through automated market makers (AMMs) that connect you to the smart contract with your requested digital assets locked up in them.

Automated market makers are algorithmic protocols that determine digital asset prices and automate asset trades on liquidity pools.

A liquidity pool gathers its assets through users called liquidity providers (also known as LPs), who contribute to a percentage of the crypto asset in a typical liquidity pool smart contract.

How do liquidity pools work?

Liquidity pools use automated market makers (AMMs) that connect users aiming to trade pairs with the appropriate smart contracts for them. AMMs are the protocols used to determine the price of digital assets, and it does a great job of providing the most reasonably accurate market price on liquidity pools.

Before liquidity pools can achieve their principal function of providing enough liquidity for crypto markets worldwide, they will require the tokens of liquidity providers.

To become a liquidity provider, you can adapt the steps below to any liquidity pool platform of your choosing:

1. Credit your crypto wallet with the crypto tokens you aim to lock up in a liquidity pool and connect it to the liquidity pool platform of your choosing or sign up on a liquidity pool platform and credit the liquidity pool wallet of your account on that platform’s wallet.
2. Find the trading pairs you’d like to invest in and deposit an equally divided portion of your crypto investment into that trading pair; for example, to invest $1000 into an ETH and USDT trading pair, you would need to deposit $500 each in both ETH and USDT on that liquidity pool.

Once you’ve made your deposit, select the period you want to have it locked up in the pool.

After the period of lockup has elapsed, you, as a liquidity provider, will be rewarded with liquidity pool tokens according to your selected trading pair and liquidity pool platform.

However, during the lockup period, you will also acquire an earning portion of the transaction fees paid to make exchanges with the pool you committed your crypto.

Some crypto liquidity pools also provide the option of staking liquidity pool tokens in exchange for earning the platform’s native token.