The role of Liquidity Pool in Decentralized Exchanges (DEXs)
In the last post, I enlightened you on how smart contracts control trading on the decentralized exchange site or complete the trading task. In today's post, I will discuss with you another one of the most important features of decentralized exchanges i.e. liquidity pool. I will try to explain to you in very simple language with detailed examples so that you can understand the matter very easily. I will explain my trading experience and knowledge as much as I have. Hope you can easily understand the function, importance, and mechanism of the liquidity pool in decentralized exchange.
When we trade on any exchange site, we have one type of currency, and we want to buy or sell another currency in exchange for it. As I said in the last post, a new account is created into which the token of the seller will be transferred and when the buyer completes the payment, the transaction will be automatically executed through the smart contract. But the big problem here is who will provide the liquidity? That is, the number of tokens you are transferring will be collected from the token exchange site until it is delivered to the buyer. Each buyer will buy a different currency and each buyer will sell a different currency, so there must be enough of each currency to supply the required amount of liquidity when this intermediate process is completed.
Liquidity in centralized exchange sites is controlled mainly through various funds provided by the owner or they collect liquidity from users through various offers. Just as shortage is a major problem in liquidity, excess liquidity is also a problem because it can reduce profits and increase fees. So the liquidity should always be kept at an optimum level which should be set based on the trading pattern and various information of the users. Thus, an exchange site is centralized. But how will the matter be done in the case of decentralized exchange? Decentralized exchanges will have a liquidity pool where users lend their funds to the liquidity pool.
By doing this, traders will not have any problem trading because enough liquidity will be deposited here from the users. If there is no liquidity, users can find the tokens they have and trade them with those who have them, but they cannot trade the tokens without liquidity. So here the liquidity pool will play a very important role for trading and decentralized exchange must have this liquidity pool. Centralized exchanges also have it but it is supplied through various sources of centralized authority.
Why do people keep money in liquidity pools or deposit their money? As they are helping to execute these transactions automatically through smart contracts, those who supply liquidity will automatically be given a portion of the trading fee. This way anyone will be willing to put their funds into the liquidity pool and the whole system will be out of centralized control. It will automatically assist in the successful completion of fund transfers and trading from one user to another user.
Like in my last post, I discussed another important topic i.e. Liquidity Pool and I hope you understand the role of Liquidity Pool and Smart Contracts in Decentralized Exchange. In the next post, I will share a few more topics and conclude the discussion on this topic. Thank you.
~ Regards,
VEIGO (Community Mod)
Wonderful article, you have clearly explained the concept of the role of liquidity pool in decentralized exchange in a very detailed and concise manner, thanks for sharing.
Many users are not familiar with the model of liquidity pool because this is a different mechanism and need some debt knowledge about the topic so thanks you for talking about it and sharing this in formative article.. your articles carry a whole lot of information that is in formative and very helpful for the community so could asked you what you are doing through your articles and I am sure it is making the community more knowledgeable.