Liquidity Pools Explained

A liquidity pool is a smart contract that holds a reserve of tokens, allowing decentralized exchanges to offer trading without a traditional order book. Users called liquidity providers (LPs) deposit pairs of tokens into the pool and earn a share of trading fees in return.

How a Liquidity Pool Works

Instead of matching buyers and sellers, a pool holds two tokens (for example, ETH and USDC) and prices trades using a mathematical formula. When a trader swaps one token for the other, the pool's balances shift and the price adjusts automatically. This is the AMM model.

How Liquidity Providers Earn

Each trade pays a small fee (often 0.3%). These fees accumulate in the pool and are distributed to LPs in proportion to their share. Some pools also pay extra rewards in a protocol's token to attract liquidity.

The Risk: Impermanent Loss

When the prices of the two pooled tokens change, the pool rebalances automatically — selling the rising token and buying the falling one. This can leave an LP with less value than if they had simply held the tokens. This is called impermanent loss. Use the Impermanent Loss Calculator to model it.

A Simple Example

You deposit $1,000 of ETH and $1,000 of USDC into a pool (50/50). Traders swap back and forth, paying fees. You earn a share of those fees. But if ETH's price rises a lot, the pool sells some of your ETH along the way — you end up with less ETH than if you had just held it. The fees may or may not make up the difference.

Things to Know

• LP tokens represent your share of the pool and can usually be redeemed for your portion of the assets.
• Pools can be exploited if the smart contract has a bug.
• Very volatile token pairs produce larger impermanent loss.
• "Impermanent" loss becomes permanent if you withdraw while the prices are still divergent.

Continue Learning

• What Is DeFi? — The ecosystem pools belong to
• What Is Impermanent Loss? — The key LP risk
• What Is Yield Farming? — Earning on top of pools

This article is for educational purposes only and is not financial advice.