Liquidity pools are one of the foundational technologies behind the current Decentralized Finance (DeFi) ecosystem. They are an essential part of automated market makers (AMM), borrow-lend protocols, yield farming, synthetic assets, on-chain insurance, blockchain gaming – the list goes on.
A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and many more functions. Since anyone can be a liquidity provider, AMMs have made market making more accessible.
Liquidity Pools vs. Order Books
To understand how liquidity pools are different, let’s look at the fundamental building block of electronic trading – the order book. Simply put, the order book is a collection of the currently open orders for a given market.
The system that matches orders with each other is called the matching engine. Along with the matching engine, the order book is the core of any centralized exchange Centralized Exchange (CEX). This model is great for facilitating efficient exchange and allowed the creation of complex financial markets. Our current stock market is based on this model.
DeFi trading, however, involves executing trades on-chain, without a centralized party holding the funds. This presents a problem when it comes to order books. Each interaction with the order book requires gas fees, which makes it much more expensive to execute trades. It also makes the job of market makers, traders who provide liquidity for trading pairs, extremely costly. This means that on a blockchain like Ethereum, an on-chain order book exchange is practically impossible. The issue behind excessive gas fees is what motivated Fallen Justice to create the FJUST token on the Binance Smart Network.
How Do Liquidity Pools Work?
Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without the need for an order book. You could think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book. For example, trading on Binance DEX is peer-to-peer since trades happen directly between user wallets.
Trading using an AMM is different. You could think of trading on an AMM as peer-to-contract.. When you’re executing a trade on an AMM, you don’t have a counter-party in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool. To avoid draining the Fallen Justice liquidity pool and ensure the Algorithm continues to fund our Operation 261 projects and our organization we've added protection features like token burns.
When you’re buying the FJUST on PancakeSwap, there isn’t a seller on the other side in the traditional sense. Instead, your activity is managed by the algorithm that governs what happens in the pool. In addition, pricing is also determined by this algorithm based on the trades that happen in the pool. If you’d like to get a deeper dive into how this works, read our AMM article.