What Is a Liquidity Pool?
A liquidity pool is a shared pot of two tokens locked in a smart contract so other people can trade between them. Instead of waiting for a buyer to meet a seller, traders swap against the pot, and a formula reprices it after every trade. Pools are the engine inside almost every DEX.
How It Actually Works
- Liquidity providers deposit equal values of two tokens, say ETH and USDC, and receive LP tokens representing their share of the pot.
- Traders swap one side for the other. Each swap tilts the ratio, and the formula moves the price accordingly.
- Every swap pays a small fee into the pool. That fee stream is why anyone provides liquidity at all.
- Providers can withdraw their share, plus accumulated fees, whenever they want.
Risks and Common Mistakes
- Impermanent loss. When the two tokens diverge in price, providers end up worth less than plain holders. Fees may or may not cover it. See impermanent loss and run my calculator before depositing.
- Smart contract risk. A bug in the pool contract can drain everything, and audits reduce rather than remove that risk.
- Creator-controlled pools. On new tokens, whoever holds the LP tokens can pull the pot. Unlocked liquidity is the loaded gun behind every rug pull.
When It Matters
Any time DeFi offers yield for depositing pairs, and any time you evaluate a small token, since its entire market is one of these pots. Context on my DeFi page.
Related Terms
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