Understanding Liquidity Pools
Liquidity pools lock tokens inside a smart contract, a concept first introduced by a project named Bancor. As you can gauge by the name of liquidity pools, they work as market makers in decentralized trading finance. In a centralized setting, the buyer wishes to buy any asset at a lower price and the seller wants to sell it at a higher price. The challenge is to match these orders. Low liquidity will cause lots of order cancellations and customer dissatisfaction. This is where the liquidity pool plays an important role.
How does this all play out in decentralized finance?
As it is already mentioned that the centralized exchange is at a disadvantage of order cancellations due to the price fluctuations. The order book model relies heavily on individual market makers to create the market for certain assets. The dependency on the user based market makers can potentially make the exchange illiquid.
