What is Liquidity Pool?

Introduction

In Decentralize Exchange (DEX), Liquidity Pool is the backbone of the platform in example the upcoming Boltr platform for swapping, lending, and farming asset in Binance Smart Chain (BEP20). In itself, the idea is profoundly simple. A liquidity pool is basically funds thrown together in a big digital pile. But what can you do with this pile in a permissionless environment, where anyone can add liquidity to it? Did someone can earn profits passively from it? Let’s explore how DeFi has iterated on the idea of liquidity pools.

A liquidity pools is a collection of funds from user that were store and lock in a smart contract in order to provide liquidity for certain asset in enabling user to make swapping, yielding, and lending. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.

Example:

1. Cheng Lee have 100 BUSD and 1000 BOLTR

2. Cheng Lee have to lock the pair of BUSD and BOLTR in a Liquidity Pools to earn yield/reward from the trading fees of the pair that he was made.

How do liquidity pools work?

Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without the need for an order book. As no direct counterparty is needed to execute trades, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges.

You could think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book. For example, trading on Binance DEX is peer-to-peer since trades happen directly between user wallets.

Trading using an AMM is different. You could think of trading on an AMM as peer-to-contract.

As we’ve mentioned, a liquidity pool is a bunch of funds deposited into a smart contract by liquidity providers. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool.

What are Liquidity Pool used for ?

So far, we’ve mostly discussed AMMs, which have been the most popular use of liquidity pools. However, as we’ve said, pooling liquidity is a profoundly simple concept, so it can be used in a number of different ways.

One of these is yield farming or liquidity mining. Liquidity pools are the basis of automated yield-generating platforms like yearn, where users add their funds to pools that are then used to generate yield.

Distributing new tokens in the hands of the right people is a very difficult problem for crypto projects. Liquidity mining has been one of the more successful approaches. Basically, the tokens are distributed algorithmically to users who put their tokens into a liquidity pool. Then, the newly minted tokens are distributed proportionally to each user’s share of the pool.

Bear in mind; these can even be tokens from other liquidity pools called pool tokens. For example, if you’re providing liquidity to Uniswap or lending funds to Compound, you’ll get tokens that represent your share in the pool. You may be able to deposit those tokens into another pool and earn a return. These chains can become quite complicated, as protocols integrate other protocols’ pool tokens into their products, and so on.

We could also think about governance as a use case. In some cases, there’s a very high threshold of token votes needed to be able to put forward a formal governance proposal. If the funds are pooled together instead, participants can rally behind a common cause they deem important for the protocol.

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Boltr is a decentralize exchange and yield aggregated platform running in KuCoin Community Chain (KCC).