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 generally shows both the price at which a user is willing to buy or sell an asset and the volume. Open orders are represented by ‘bids’ (buy orders) and ‘asks’ (sell orders).
In the BTC/AUD trading pair example, the order book contains corresponding buy and sell orders placed by users to buy or sell bitcoin for AUS dollars. In this case, AUD is used to display the Bitcoin price. For example, there could be a buy order on the order books to buy 1 bitcoin at a price of A$50,000. Trading pairs are not just limited to BTC/AUD, most exchanges have up to hundreds of trading pairs (e.g. BTC/USDT, ETH/AUD, etc.).
An order book can be thought of as a marketplace because any user can place an open order there, which will remain in place until the order is filled or canceled by the user. However, placing an order is no guarantee that the order will be executed. When a user places a buy order, another user on that exchange must place a corresponding sell order for the same amount. Order fulfillment helps reflect the supply and demand strength of the exchange or platform in question.
Because the buy and sell prices are displayed in real time, market participants can make informed decisions. There are a number of visual indicators to help identify market trends and dynamics over time. Candlestick charts represent the current and previous value of the market. While depth charts show bid and ask lines that represent the buy and sell orders for a given asset at different prices. This provides a good insight into the supply and demand of an asset, as well as trends in how much an asset has sold at a given price point.
What is a liquidity pool?
A liquidity pool is a collection of funds anchored in a smart contract that provides liquidity to decentralized exchanges (DEXs). They are essential to the DeFi ecosystem and the Automated Market Maker Model (AMM). Traditional order book markets can be thought of as peer-to-peer trading, where buyers and sellers are linked by matching orders. Trading with an AMM can be considered peer-to-contract.
AMM-based platforms leverage liquidity pools to enable trading via governance algorithms that keep the price of the tokens in each pool relative to each other. Popular DEXs use an algorithm to maintain price ratios. This helps manage the cost and ratio of pooled tokens as demand increases, allowing the pool to continuously provide liquidity.
Users are incentivized to provide digital assets to pools by becoming Liquidity Providers (LPs). Providers are then awarded rewards in the form of trading fees in proportion to their contribution to the pool. In order to deposit funds into a pool, the same amount of liquidity must be provided per token. For example, $100 worth of ETH and $100 worth of USDT would need to be delivered to an ETH/USDT trading pair. Rewards vary by platform, with certain “incentive” pools granting providers an allocation of newly generated crypto tokens called LP tokens. This process is also known as “yield farming”.
One of the advantages of using a liquidity pool is that buyers and sellers do not have to exchange assets, only the pre-funded liquidity pool. Allows trades with limited slippage, even on more volatile trading pairs, provided the liquidity pool is large enough.
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