Liquidity pools, at their simplest, are a collective pool of funds which are used to provide liquidity for a given market and generate rewards in return.
Liquidity is an important characteristic of any market, which involves the trade-off between how quickly an asset can be sold and at what price. Historically, cash is understood to be the most liquid asset, as it can be ‘sold’ for goods and services instantly with no loss of value. Such a highly liquid asset always has ready buyers and sellers. In a market which is illiquid, i.e. low in liquidity, an asset must be discounted for it to be sold quickly. This may happen because the value of the asset is uncertain, or that a sizeable market for it simply does not exist.
The entities which provide liquidity for a market and known as market makers. Their core service is to allow for the immediacy of a transaction that needs to go through, by absorbing the buy or sell order. Their presence is of crucial importance for the market’s health, as they complement the behaviour of speculators. Speculators work on the basis of buying and holding assets for various durations of time, based on their predictions of how the assets’ price might change in the future.
In DeFi, automated market makers (AMMs) are made up of many liquidity pools which hold funds, often in pairs. These pools allow for traders to swap between the assets for a small fee. The funds are deposited into the pool by users known as liquidity providers (LPs), who receive the fees (and often other incentives) as rewards.
AMMs are the decentralised alternative to large market making institutions which served the same function in traditional finance. Any user can provide liquidity to these pools, earning a portion of the pool's fees as well as potential staking rewards in a practice known as yield farming.