Liquidity is a fundamental part of both the crypto and financial markets. It is the manner in which assets are converted to cash quickly and efficiently, avoiding drastic price swings. If an asset is illiquid, it takes a long time before it is converted to cash. You could also face slippage, which is the difference in the price you wanted to sell an asset for vs. the price it actually sold for.

Liquidity pools play a large part in creating a liquid decentralized finance (DeFi) system.

Imagine waiting to order inside a fast-food restaurant. Liquidity is comparable to having lots of cashiers. That would speed up orders and transactions, making customers happy. On the other hand, illiquidity is comparable to having only one cashier with a long line of customers. That would lead to slower orders and slower transactions, creating unhappy customers.

In traditional finance, liquidity is provided by buyers and sellers of an asset. In contrast, DeFi relies on liquidity pools to function. A decentralized exchange (DEX) without liquidity is equivalent to a plant without water. It won’t survive. Liquidity pools provide a lifeline to DEXs.

A liquidity pool is a digital pile of cryptocurrency locked in a smart contract. This results in creating liquidity for faster transactions.

A major component of a liquidity pool are automated market makers (AMMs). An AMM is a protocol that uses liquidity pools to allow digital assets to be traded in an automated way rather than through a traditional market of buyers and sellers.

In other words, users of an AMM platform supply liquidity pools with tokens, and the price of the tokens in the pool is determined by a mathematical formula of the AMM itself.

Liquidity pools are also essential for yield farming and blockchain-based online games.

Liquidity pools are designed to incentivize users of different crypto platforms, called liquidity providers (LPs). After a certain amount of time, LPs are rewarded with a fraction of fees and incentives, equivalent to the amount of liquidity they supplied, called liquidity provider tokens (LPTs). LP tokens can then be used in different ways on a DeFi network.

SushiSwap (SUSHI) and Uniswap are common DeFi exchanges that use liquidity pools on the Ethereum network containing ERC-20 tokens. At the same time, PancakeSwap uses BEP-20 tokens on the BNB Chain.

Read more: Decentralized Liquidity Is the Backbone of DeFi

In a trade, traders or investors can encounter a difference between the expected price and the executed price. That is common in both traditional and crypto markets. The liquidity pool aims to eliminate the issues of illiquid markets by giving incentives to its users and providing liquidity for a share of trading fees.

Trades with liquidity pool programs like Uniswap don't require matching the expected price and the executed price. AMMs, which are programmed to facilitate trades efficiently by eliminating the gap between the buyers and sellers of crypto tokens, make trades on DEX markets easy and reliable.

What are the incentives for liquidity pool providers/depositors?

There are multiple ways for a liquidity provider to earn rewards for providing liquidity with LP tokens, including yield farming.

Read More: What Is Yield Farming? The Rocket Fuel of DeFi, Explained

This allows a liquidity provider to collect high returns for a slightly higher risk by distributing their funds to trading pairs and incentivizing pools with the highest trading fee and LP token payouts across other platforms.

As mentioned above, a typical liquidity pool motivates and rewards its users for staking their digital assets in a pool. Rewards can come in the form of crypto rewards or a fraction of trading fees from exchanges where they pool their assets in.

Here is an example of how that works, with a trader investing $20,000 in a BTC-USDT liquidity pool using SushiSwap.

The steps would be as follows:

The BTC-USDT pair that was originally deposited would be earning a portion of the fees collected from exchanges on that liquidity pool. In addition, you would be earning SUSHI tokens in exchange for staking your LPTs.

Many decentralized platforms leverage automated market makers to use liquid pools for permitting digital assets to be traded in an automated and permissionless way. In fact, there are popular platforms that center their operations on liquidity pools.

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Read More: How to Stay Safe in DeFi