A liquidity pool is essentially a reserve consisting of cryptocurrencies that are locked in a smart contract together. They are primarily used to facilitate decentralised finance (DeFi)-related activities, such as lending, trading, and swapping, on a decentralised exchange (DEX).
This technology functions via a mechanism that allows users, or liquidity providers (LPs), to pool their digital assets in a DEX’s smart contract. In exchange, the LPs receive certain rewards (typically in the form of trading fees) in proportion to the liquidity they supplied.
The benefit of a liquidity pool is that it does not require a buyer to match with a seller for a transaction to occur. Instead, the system automatically uses the tokens in the liquidity pool to take the opposite side of a trade. In doing so, it helps close the gap between the expected price and the executed price of an order while vastly improving efficiency and reliability.
Examples of liquidity pools include Uniswap, Balancer, Bancor, and Curve DAO.
