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Liquidity Pools: The Foundation of DeFi

Liquidity pools are the foundation of the DeFi ecosystem. Moreover, it tries to resolve some specific issues that have been bugging the crypto community for a long time.

11 Sep
Liquidity pools and DeFi

DeFi has taken the whole crypto industry by storm.

Unless you have been meditating on a silent retreat for the past six months, surely you have heard about liquidity pools, but may not know all of the details. This article will try to explain what liquidity pools are and why they are one of the integral parts of the DeFi ecosystem.

To explain liquidity pools, one has to understand a more basic form of trading mechanism: order book trading.

Order Book Trading

Order book trading is the most commonly-used trading mechanism implemented by crypto exchanges and is used to match a buyer and seller.

In order book trading, a buyer/seller places an order on a particular price, with buyers placing buy orders and sellers placing sell orders. A matching engine will then match an opposite order for the price offered. If found, then the order is executed and filled.

In order book trading, there are typically two types of traders:

  • Takers
  • Makers

Takers are all the traders who would take the bid/ask price that is already in the order book.

Makers are the traders who place orders for prices that are not currently available in the order books.

The order book trading mechanism typically works well for coins with demand or liquidity. However, tokens with low volume or liquidity will face issues when using order book trading, as a single large order from one trader could drastically swing the price in both ways. Commonly, small-cap coins or new exchanges will suffer from low liquidity, and it can cause price distortions or even allow for market manipulation.

A liquidity pool refers to a pool of tokens from users that are locked in smart contracts. Liquidity pools were designed to address and rectify this problem and to offer liquidity at different price levels. 

Workings of a Liquidity Pool

Liquidity pools attempt to effectively resolve the issue of low liquidity and consequently ensure that a token’s price does not swing drastically after executing the order of a single large trade. They might also minimize a bid/ask spread and eliminate unnatural arbitrage opportunities.

To increase participation from users, decentralized exchanges offer incentives to those who deposit into the liquidity pools.

For a user to participate in a liquidity pool and reap its rewards, the person has to deposit assets into the liquidity pool. Liquidity pools are governed by one or more smart contracts.

The number of assets that need to be deposited and the proportionate ratio of each token will vary with different DeFi platforms.

For example, in Uniswap, if a person wants to participate in the liquidity pool for the ETH/DAI pair, then they will have to deposit both the coins in equivalent USD. Hence, if the person decides to deposit 1 ETH, then the equivalent USD amount of DAI should also be deposited. At the time of writing, this would amount to ~405 DAI.

The person participating in the liquidity pool is incentivized through the fees of the trading pair and the percentage holding for the user in that particular liquidity pool. That is if the trading fees charged by the exchange on a single trade are equal to 0.3% and the equivalent value of token deposited by the user (US$405 according to the above example) in the liquidity pool amounts to 0.05% of the total liquidity pool, then the person would receive 0.05% of the 0.3% trading fee.

It is important to note that even though the user initially deposits at a 50-50 ratio into the liquidity pool, there is no guarantee that during the time of withdrawal, the user will get the two assets in the same ratio. It is very well possible that due to the trading of assets in the liquidity pool, the ratio at the time of withdrawal will be completely different.

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Liquidity Pool Token and Yield Farming

A user who deposits the token into the liquidity pool is supplied by the exchange’s liquidity pool token, which would be proportionate to the value of the liquidity provided. This is how the exchange will know how much the user has deposited in the liquidity pool.

Moreover, once the user decides to withdraw the tokens from the liquidity pool and remove the liquidity, the exchange-provided tokens will be burned, and the initial tokens with the accrued incentives will be returned to the user.

Yield farming is a method used by investors in DeFi to maximize the return on investment, using different products in the DeFi ecosystem.

Although there are different ways to maximize the returns using yield farming, the most commonly used method is by utilizing the Liquidity tokens, which the DeFi platforms provide.

As mentioned earlier, DeFi platforms provide liquidity pool tokens to the users for using the DeFi services like lending, borrowing, or depositing in liquidity pools. 

A user can use the liquidity pool tokens during the period of the smart contract, like any other tokens. Hence, to maximize the return, a user can deposit this token in a different platform that accepts the liquidity pool token to get additional yield.

Moreover, a user could repeat this with any number of platforms and any number of liquidity pool tokens, that is, if the platform accepts the said token.

Hence, by using yield farming, a user can compound two or more interest rates and ultimately maximize the returns.

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Liquidity pools play a fundamental role in the DeFi ecosystem, and the concept has been able to improve the level of decentralization in the space.

Liquidity pools provide ease of use for both the user and the exchanges, and to participate in liquidity pools a user does not have to meet any special eligibility criteria, which means anyone can participate in providing liquidity for a token pair.

Centralization is one of the primary issues that blockchain and cryptocurrencies have set out to address. However, centralized exchanges have had to rely on very few market-makers to provide liquidity for coins and tokens for a long time.

Liquidity pools have been able to provide a solution for these issues related to centralization. Since there is an incentive to participate in liquidity pools, user participation increases simultaneously. This will ultimately result in more decentralization and has the potential to address the problem of market manipulation, which is one of the primary concerns associated with the transparency of the crypto markets.

With the sudden surge of DeFi and its related products, decentralized exchanges can address this concern of centralization with the help of liquidity pools.

It is always refreshing to see a relatively simple concept like liquidity pools providing a solution to a large, complex problem like centralization, which has been one of the major concerns for the whole crypto community.