Classically in any financial market, other than the cryptocurrency market, the buyer and the seller meet in the marketplace to conduct a transaction. 

This transaction relies heavily on market makers, who buy and sell from traders in different markets. However, replicating this in a decentralized financial market like the cryptocurrency market is not very efficient because it is slow and expensive.

Therefore, liquidity pools were created to always provide liquidity for the huge amount of transactions done in the cryptocurrency market. Liquidity providers contribute to this pool by adding an equal ratio of crypto coins.

But how are these liquidity pools created? Liquidity pools are created using smart contracts where anyone can provide liquidity for different rewards. These pools are usually a combination of two different cryptocurrencies and traders can exchange one for another in a fast and smooth way. 

These liquidity pools are not limited to only two tokes, and some liquidity pools can contain up to 8 cryptocurrencies.

Liquidity pools are comprised of liquidity providers who create these pools and set the price. There are protocols that secure these pools in virtually locked contracts. Also, there are exchanges and OTC brokers who use them to facilitate trading.

Automatic Market Making is the mechanism that admins the transaction process of the liquidity pools. Using the AMM, all three participants of the liquidity pool interact with each other.

Liquidity providers

The liquidity providers are investors, banks, or financial institutions that add equal pairs of tokens in one pool. One or more liquidity providers can contribute to one liquidity pool, and they set the price according to the market price.

If the price of the tokens in one pool diverges from the crypto market, it will make these pools not useful and is more likely to create liquidity issues.

In return, liquidity providers receive a special token or interest rate, to compensate them for adding to the pool. The liquidity provider or LP token that they receive entitles them to a share of the revenue generated by the pool according to their contribution.

Exchanges

Crypto exchanges are marketplaces where cryptocurrencies are traded. They are platforms that offer several coins, and where a huge number of buyers and sellers come to trade them.

But most of these exchanges use traditional order books in order to create liquidity. For highly traded assets, this might do the job, but for assets that are not traded as much, this order book becomes a problem.

Because of this, exchanges started to utilize these liquidity pools in order to make the trading experience on their platform smooth and fast. It does not matter if these are centralized or decentralized exchanges, both of them are benefiting from these pools. 

But what benefit do traders get from providing liquidity? Well, the answer to this question is crypto. Whenever we provide liquidity for an exchange, in return we will get a native token of that exchange as a reward. For example, when we provide liquidity for Binance, we receive BNB, their native token, as a reward. Some liquidity pools even reward traders with the same token they provided liquidity for.

Well, we know that the role of liquidity pools is to create liquidity. But why are we so desperate for liquidity? 

Cryptocurrencies are a relatively new concept of financial trading/investment, but they still managed to gather global attention and now stand beside other financial assets such as stocks, FX, and more.

Because of this popularity, a huge number of traders are joining the market each day to try their luck in this volatile market, and this is where the problem lies. Cryptocurrencies tend to be highly volatile which means that their price changes consistently. So if we were to send a buy order of a set amount of tokens, the price that the exchange gave us at the start might not be the final price because of slippage. If the market could not fulfill our order in time and the price changes, we will be paying a different price than when we sent the order.

Liquidity pools help us to execute these orders in seconds and avoid any slippages.

How do these pools affect the price of crypto tokens

The liquidity pools aim to have the tokens always available using automatic market-making, which makes the transactions faster. For example, if a pool contains an equal amount of BNB/ETH, it will be faster for a trader to buy ERC-20 (the ETH token) because it is always available.

The protocols that govern the liquidity pools motivate the liquidity providers by offering them a special token, or in most cases a fixed interest rate for every transaction that takes place in the liquidity pool.

Liquidity providers need to maintain an equal balance between the tokens in the pool. Otherwise, if there is an unequal amount of tokens, it will cause an imbalance in the demand and supply law, and eventually will lead to price changes.

However, ensuring a balance is necessary in order to have a token price that copes with the market price, and any parity from the market price will cause the pool to be not practical, expensive, and unprofitable for the liquidity providers.

• Liquidity pools contain cryptocurrency tokens and use automatic market-making to always ensure the liquidity of these tokens
• Transactions conducted in the liquidity pools are faster and smoother because there is higher liquidity, and traders do not need to wait for a seller in the market
• Liquidity providers supply these pools with an equal ratio of token pairs, in exchange they receive a royalty token or an interest rate from any transaction
• Liquidity pools use different protocols to be registered on a blockchain like the Ethereum blockchain, these protocols take care of the token’s security and maintenance