Order Books vs. Liquidity Pools

What is an Order Book?

An order book is a list of open buy and sell orders available on an exchange for a specific trading pair (e.g BTC/AUD). It will generally display both the price a user is willing to buy or sell an asset for and the volume. Open orders are represented by “bids” (buy orders) and “asks” (sell orders).

In the example of the BTC/AUD trading pair, the order book will have corresponding buy and sell orders that users have placed to either buy or sell Bitcoin for AUS Dollars. In this instance, AUD is being used to display the price of Bitcoin. For example, there could be a buy order to purchase 1 Bitcoin at the price of $50,000 AUD on the order books. Trading pairs are not limited to only BTC/AUD, most exchanges will have up to hundreds of trading pairs available (e.g BTC/USDT, ETH/AUD, etc).

An order book can be thought of as a marketplace as it is where any user can place an open order, which will remain until the order is either fulfilled or canceled by the user. However, placing an order does not ensure that it will be completed. If a user is placing a buy order, another user on that exchange will need to place a corresponding sell order for the same amount. The fulfillment of orders will help to display the supply and demand strength of said exchange or platform.

As the buy and sell prices are shown in real time, market participants are able to make informed decisions. There are a number of visual displays that will help to read the market trends and dynamics over time. Candle-stick charts present the market’s current and previous value. While depth charts will show bid and ask lines representing the buy and sell orders for a specific asset at various prices. This provides great insight to the supply and demand of an asset, as well as the trends of how much an asset has sold at a particular price point.

What is a Liquidity Pool?

A liquidity pool is a collection of funds locked into a smart contract that provides liquidity for decentralized exchanges (DEXs). They are essential to the DeFi ecosystem and the automated market maker model (AMM). Where traditional order book markets can be thought of as peer-to-peer trading, where buyers and sellers are linked by corresponding orders. Trading using an AMM can be thought of as peer-to-contract.

AMM based platforms use liquidity pools to allow trading via governance algorithms that maintain the price of tokens in any pool relative to one another. Popular DEXs utilise an algorithm to help maintain price ratios, this helps to manage the cost and ratio of pooled tokens as demand increases, allowing the pool to consistently provide liquidity.

Users are incentivised to supply digital assets to pools by becoming liquidity providers (LPs). Rewards are then issued to providers in the form of trading fees relative to their contribution to the pool. In order to deposit funds into a pool, an equal amount of liquidity per token needs to be supplied. For example, $100 worth of ETH and $100 worth of USDT would have to be supplied to an ETH/USDT trading pair. Rewards across platforms will vary, with certain “incentivised” pools granting providers an allocation of newly generated crypto tokens known as LP tokens. This process is also known as “yield farming”.

One of the benefits of using a liquidity pool is that a buyer and seller are not required to exchange assets, just the pre-funded liquidity pool. Allowing for trades with limited slippage, even with more volatile trading pairs, given the liquidity pool is deep enough.