What is liquidity pool?

What is an Order Book

• A trade is transacted when buyer and seller meet at the same price. It directly connects buyer and seller
• cons: You have to set a price that someone else is willing to buy or sell at
• solution: Liquidity pool

What is a liquidity pool?

• An algorithm called Automated Market Maker(AMM) determines the price of an asset, and trade is peer-to-pool, rather than peer-to-peer.
• Because trade is peer-to-pool, sellers can sell there tokens even though there are no buyers.

How does a liquidity pool work?

• A liquidity pool is composed of two different tokens, and buyers or sellers can swap their tokens with a ratio determined by AMM.
• Dexes hook up two different liquidity pools together in order to make it possible to swap any two tokens
• Liquidity Providers(LP) receives transaction fees for rewards of providing liquidity. If there are only a few LP, return is high but the price is volatile. If LP is big, return is smaller but the price if more stable
• As larger the liquidity, it’s harder to change the price of a token.
• Most liquidity pools want to have 50:50 ratio (in prices) of tokens in it.

Arbitrage Trades

• As liquidity changes, the price of a token will be different from that of other exchanges. This helps to keep a stable price of a token.