Liquidity pool

A liquidity pool is a pot of tokens locked in a smart contract that anyone can trade against. Pools are the engine of most decentralized exchanges: instead of waiting for a buyer to meet a seller, a trader swaps directly with the pool, and the price adjusts automatically.

How a liquidity pool works

Users called liquidity providers (LPs) deposit two tokens in equal value, for example ETH and USDC. In return, they receive a record of their share of the pool: a token or, on newer designs, a position NFT. Every trade pays a fee that is added to the pool, so LPs earn a share of trading fees in proportion to their stake.

The price comes from a formula. In the classic constant product model used by Uniswap, the two reserves multiplied together must stay the same (x × y = k). When someone buys ETH, the ETH reserve shrinks and the USDC reserve grows, so ETH becomes more expensive in that pool. Arbitrage traders then bring the pool’s price back in line with other markets.

A concrete example

Imagine a pool holding 10 ETH and 30,000 USDC, so 1 ETH is worth 3,000 USDC and k equals 300,000. A trader wants to buy 1 ETH. After the trade, the pool must hold 9 ETH, so it needs 300,000 ÷ 9 = 33,333 USDC. The trader pays about 3,333 USDC plus the fee, well above 3,000. This gap, the price impact, shows why deep pools give better prices than small ones.

Why it matters for users

• Pools let any token be traded at any time, without a market maker.
• Holders can earn trading fees on assets they own, and pools are the building block of yield farming.
• Pool depth tells traders how much slippage to expect.

Risks and limits

• Impermanent loss: when prices move, LPs can end up worth less than if they had simply held the two tokens.
• Smart contract risk: a bug or exploit can drain the pool.
• Token risk: a pool is only as good as the tokens in it; a worthless token can leave LPs holding only that token.
• Fees earned are variable and depend on trading volume.