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What is a Liquidity pool?

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What is a Liquidity pool?

A liquidity pool is a pool of tokens on a decentralized exchange to facilitate trading and provide liquidity. This allows users of a DEX to execute their buy or sell orders without having to wait for another buyer or seller to show up. The opposite of a liquidity pool is the Order Book model used on centralized exchanges where buyers are looking to buy at the lowest price possible and sellers are looking to sell their assets at the highest price that is possible. This can take time if buyers and sellers can’t reach an agreement.


On a DEX anyone can become a part of the liquidity pool to earn passive income. Token pairs are locked into the pool and are governed by a smart contract on the blockchain network. For example, you can put a pair of ETH/ADA into a liquidity pool in a 50-50 ratio. If you put a total of $1000 using this pair in a liquidity pool, $500 worth of ETH and $500 worth of ADA would be locked. This allows you to function as an exchange. Whenever someone wants to buy ETH or ADA, he will give you one of the tokens and in exchange get the other one from the pair. There is a small fee charged for such transactions which go into your wallet as a reward for providing liquidity.


Liquidity pools can affect the price of a token on DEX. Consider the above-mentioned ETH/ADA pair again. If a lot of people buy ADA from the ETH/ADA pool, the price of ADA would go up, while the price of ETH would come down as the supply increases when users swap their ETH for ADA.