What are Liquidity Pools and How Do They Work?

What are Liquidity Pools and How Do They Work? 

There are a multitude of options available when trading cryptocurrency, and it can be overwhelming. Luckily, we can offer an insight into some of the more detailed areas, such as how to work with liquidity pools when trading Swyftx Australia Ethereum.

What is a liquidity pool? It incorporates large funds of money to ease token trading on decentralised exchanges, also known as DEX. These liquidity pools are crowdsourced pools of cryptocurrency which provides needed liquidity. This enables digital assets to be traded using automated market makers. This means that users can trade their assets on decentralised exchanges without needing to rely on a traditional market maker or centralised financial market model, instead enabling it to work within a decentralised finance ecosystem (DeFi).

So let’s dive deeper into liquidity pools and how they can assist you with Swyftx Australia Ethereum.

What is a liquidity pool?

Liquidity pools are one of the key elements which facilitate operations of several functions, including automated market makers, yield farming, synthetic assets, lending protocols and many more. In essence, it allows users to deposit different crypto-assets into a vault. By bringing all the assets together the DEX markets can be more liquid as users can then create “trading pairs” to create a market. Users can then use these trading pairs to trade different cryptocurrencies for each other. By adding liquidity (their assets) into a liquidity pool, users are rewarded by earning trading fees for the trades executed within that pool. trading fees

In essence, the liquidity pool is similar to a smart contract with the whole process handled automatically by code. This means that liquidity pools are permissionless. Why is this important in decentralised finance? It enhances trading with every process handled automatically, meaning you can rest assured your transaction will be secure.

How do liquidity pools work?

Traditional markets use centralised exchanges. Even though all markets are now traded on online exchanges, they still present numerous barriers for DeFi. Traditional exchanges rely heavily on order books and market makers in order to boost liquidity and facilitate trade. However, in DeFi we see traded happening rapidly on-chain, even moreso than you see on traditional exchanges, and this would likely results in high fees for its users.

In cryptotrading, we tend to see automated market makers which provide access to on-chain trading and can govern prices without relying on order books. They utilise intricate algorithms and smart contracts to ensure prices are balanced, moving in line with supply and emand pressures. This also allows cryptotraders to make positions using illiquid pairs which can be difficult to do on a traditional exchange.

When you are using an automated market maker, you are trading against the liquidity in the pool rather than a single position. This opens up a world of opportunity with any token pair possible and provides you with more positions to trade Swyftx Australian Ethereum as long as there is sufficient liquidity in the pool.

Yield farming

So how do you encourage traders to operate in liquidity pools? Well there is just one word: incentives. Like every part of trading and business, it’s important to offer potential traders an incentive to deposit and trade their cryptocurrency in liquidity pools. Many DeFi protocols offer incentives in the form of liquidity pool tokens which represent the user’s percentage in the liquidity pool. These tokens have a value of their own.

This has become known as yield farming with user’s assets secured in liquidity pools for a set period of time. The reward is then totalled as the annual percentage yield o their contribution.

This is known as yield farming or liquidity mining. Users’ funds are typically locked up for a set period of time, with the reward calculated as the annual percentage yield (APY) of their contribution. These rewards are then financed by the various protocol’s fees or can even be newly minted. So keep this in mind when you start investigating Swyftx Australia Ethereum for example, as many Ethereum deposits will be made using an ERC-20 token with the yield rewards issued the same.

This isn’t the case for all cryptocurrencies or exchanges however – some blockchains may choose to use their own token standards. However, they all tend to follow a similar model. Rewards for pledging assets into liquidity pools are funded by the protocol’s fees or are newly minted. Other blockchains have their own token standards but follow a similar model.

The future of liquidity pools

Just like cryptocurrency itself, the future is bright and constantly expanding for liquidity pools, especially as we continue to explore blockchain opportunities. Cross-chain bridges, for example, are a new emerging technology which enables different blockchains to operate between themselves securely. This opens up trading between the blockchains by facilitating the communication between the different token standards and smart contract codes.

This could play a huge role in the future of DeFi as it further enhances liquidity. Opening liquidity pools to cross-chain bridges would further open up opportunities for traders interesting in illiquid pairs.

Liquidity pools have also proven to be a popular option for boosting voting power with governance tokens. When more people with similar interests and beliefs pool their governance token together, they can create change in different protocols and system operations. There are many more opportunities on the horizon as the role of the liquidity pool continues to expand.

Liquidity pool risks

Like everything else in life, there are some risks when it comes to liquidity pools although they tend to be quite rare. The general assumption is that value will be generated whenever assets are added to a liquidity pool, but there is always the chance of encountering the following risks, similar to trading on traditional financial markets.

  • Smart contract bugs: Because automated market makers rely heavily on smart contracts, there is a potential security risk due to the possibility of human error, bugs or exploits. Protocols will work overtime to reduce the potential risk, but it is something to be aware of in the crypto community.
  • “Impermanent loss”: In most cases, value increases when assets are added to a liquidity pool. However, sometimes that value changes rapidly, and can be impacted by an imbalance in the pool. This opens the door for arbitrage traders to exploit the value of the liquidity pool for their own gains. This in turn means you can experience loss if the prices changes drastically from when you “locked-in” your assets to when you actually deposit them into the pool.


Already viewed as essential, liquidity pools will only continue to grow in importance. As we continue to see the amount of tokens exchanged also grow, we will see liquidity pools solve the illiquidity problems the sector currently faces. When it comes trading Swyftx Australia Ethereum, the best option is to delve into the liquidity pool as it will enhance your earnings with minimal risk.

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