In the most basic sense, a Liquidity Pool is like a big pot of crypto tokens (or coins) that sit in a decentralised exchange (DEX).

Investors deposit their crypto tokens or coins they bought elsewhere into this pot, thus providing the “liquidity” to the DEX’s users.

In return, investors get a bit of the trading fees when these tokens are used in trades by the users of the DEX.

Thus Liquidity Pools are the lifeblood of a DEX. Without them, the DEX essentially has no inventory of tokens or coins for any trade to happen.

In traditional Centralised Exchanges (CEXs) like Binance.com, the exchange itself often acts as a market maker or matches buy/sell orders from its user base.

However, DEXs operate on a peer-to-peer model and rely on Liquidity Pools to function.

Here’s a simple way to look at it:

Centralised Exchange:
Think of it as a store where the store owner stocks the shelves. They buy or borrow inventory (in this case, cryptocurrencies) from suppliers or use their capital to keep these items in stock. When you want to buy something in the store, you can because the store has inventory.

Decentralised Exchange (DEX):
Imagine a farmers’ market where individual vendors (Liquidity Providers) come and set up stalls (liquidity pools). If no one sets up a stall, there’s nothing to buy — the market (DEX) exists, but it’s empty.

So without Liquidity Pools filled by Liquidity Providers, a DEX would be like a market with no stalls, or a store with empty shelves. The DEX wouldn’t be able to facilitate trades, defeating its primary purpose.

There are 2 types of Liquidity Pools:

1. Single Crypto Liquidity Pool

In a single crypto Liquidity Pool, you’re dealing with only one type of cryptocurrency. Let’s say there is a Liquidity Pool just for Ethereum (ETH).

Investors deposit their ETH into the pool. When someone wants to trade ETH for something else, they can use the tokens from this pool.

2. Paired Crypto Liquidity Pool

In a paired crypto Liquidity Pool, two different types of cryptocurrencies are stored. Let’s say the pair is ETH and USDT (a stablecoin).

Investors deposit an equal value of both. So if you put in $1000 worth of ETH, you would also put in $1000 worth of USDT.

When someone in the DEX wants to trade ETH for USDT or vice versa, they use this pool. Paired Liquidity Pools are more common than single crypto Liquidity Pools and allow for direct trading between the two tokens.

Differences & Relevance to Investors

1. Risk:

Single crypto Liquidity Pools are generally less risky as you are only exposed to the volatility of one asset.

Paired Liquidity Pools where you invest a pair of cryptos like LINK/ETH expose you to two, which could mean double the fun or double the trouble — unless you make one of the cryptos in the pair a stablecoin — like ETH/USDT where USDT is the stablecoin.

2. Reward:

Paired Liquidity Pools often have the potential for higher returns since they facilitate more trades (more trading fees for you).

3. Impermanent Loss:

This is the risk of losing money in a paired Liquidity Pool due to price volatility of cryptos.