Liquidity Pools

Updated: Mar 23

Decentralised finance is one of the fastest growing sectors in Crypto. The rise of staking, yield farming and borrow-lend protocols amongst other things has led to a drastic increase in on-chain activity. According to DeFi Pulse, a website which provides analytics and rankings of DeFi protocols, the total value locked (TVL) across all DeFi protocols currently sits at around 76 billion dollars. DeFi continues to rapidly expand with a wide range of new uses. One key aspect to this rapid expansion is a technology known as liquidity pools. So, what are liquidity pools? How do they work? And why do we need them?

Order books In traditional finance, trading is made possible using a system known as an order book. The order book, simply put, is a list of currently open orders for any given market. It uses a system called a matching engine that matches buy and sell orders to facilitate trading. In the order book model buyers and sellers place their orders, buyers try to buy an asset for as little as possible whereas sellers try to sell the same asset for as much as possible. For a trade to take place both a buyer and seller must meet at the same price. The matching engine is used to find two matching buy and sell orders. If two matching orders cannot be found it is the job of a market maker to step in and provide liquidity so that trading can take place. Market makers – usually banks or brokerages – stand by and are always ready to buy or sell a particular asset at market value. They help to keep trading smooth and efficient. For the most part this system works efficiently in traditional finance. However, when used in cryptocurrency...

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