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What is a Liquidity Pool?
What is a Liquidity Pool?
Trader Joe avatar
Written by Trader Joe
Updated over a week ago

WTF is a Liquidity Pool?

Have you ever actually wondered what a 'Liquidity Pool' is and how does it actually work? No problem, we have you covered with this article.

Decentralised Exchanges (DEX) allow users to trade tokens in a permissionless manner and without restriction. To do that, they rely on 'liquidity pools'

On a traditional DEX, a liquidity pool is a smart contract associated with each token pair. The Smart Contract performs two important functions:

  • Stores liquidity deposited by users

  • Houses logic that allows tokens to be swapped

One of the most essential components of that logic is the pricing function. Most DEXes use the x*y=k formula to derive the price of tokens for trading. Each liquidity pool tracks the amount of asset x and asset y and calculates the price using these reserves.

When users deposit assets in such a pool, they gain a proportional share (eg 5%). Users may experience Impermanent Loss inside the Liquidity Pool as their assets are used for trading. However, the trading fees accrued from each swap act as compensation for the IL experienced.

However... Traditional liquidity pools suffer from various issues:

  • Ineffective pricing that can result in slippage for traders

  • Fees often not being large enough to fully compensate for the Impermanent Loss


Liquidity Book Pools are built different Each pool is divided into numerous price bins. Each bin has its own fixed price and behaves like a constant sum market, which means it doesn't rely on reserves of tokens x and y to calculate the price.

When depositing assets into pools in the Liquidity Book, users specify which pools they want to deposit into. This means they can choose at which prices they want to provide liquidity. This is in contrast to x*y=k pools, where liquidity is always provided from 0 to infinity.

Each pool in Liquidity Book also keeps track of volatility through the novel Volatility Accumulator. This allows the pool to increase or decrease fees to help compensate liquidity providers for the Impermanent Loss they experience during volatile conditions.

As a result, Liquidity Book's pools can offer trades with zero or minimal slippage, all while making sure users are properly compensated for the risks they take.

Liquidity Pools are ever evolving in this industry, moving further towards total capital efficiency, whilst retaining the much needed aspect of being permissionless and trusted. We will likely see continued innovation in the coming years with this fundamental aspect of #DeFi

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