A liquidity pool-based decentralized exchange (DEX) is a type of DEX that uses an automated market maker (AMM) algorithm to determine the price of assets based on supply and demand. Instead of relying on order books like traditional centralized exchanges or order book-based DEXs, liquidity pool-based DEXs use liquidity pools to facilitate trades.
A liquidity pool is a pool of tokens that are locked into a smart contract on the blockchain, and users can trade these tokens directly with the liquidity pool. The pool consists of two or more tokens, typically a stablecoin and another cryptocurrency or token.
When a user wants to trade a token on a liquidity pool-based DEX, they deposit the token into the pool, and in exchange, they receive a proportional amount of liquidity pool tokens, which represent the user's share of the pool. These liquidity pool tokens can be used to withdraw the original token at any time, and they can also be traded on the DEX.
The price of a token on a liquidity pool-based DEX is determined by an automated market maker algorithm, which adjusts the price based on the ratio of the two tokens in the pool. When a user makes a trade, they pay a fee, which is used to incentivize liquidity providers to deposit more tokens into the pool.
Popular examples of liquidity pool-based DEXs include Uniswap, SushiSwap, and Curve. These DEXs have gained popularity due to their ease of use, low fees, and high liquidity. However, they can be susceptible to impermanent loss, which is a temporary loss of funds for liquidity providers due to fluctuations in the price of the tokens in the pool.