Instead of matching individual buyers and sellers, many decentralised exchanges trade against a communal reserve of assets. That reserve is a liquidity pool. Users called liquidity providers deposit a pair of tokens, say ETH and a stablecoin, and the pool's smart contract then prices swaps automatically based on the ratio of assets it holds. Every trade nudges that ratio, which is how the price moves.
Why would anyone supply a pool? Because traders pay a small fee on each swap, and those fees are shared among the liquidity providers in proportion to their deposit. It is a way to earn a return from assets you already hold. Pools are the fuel that makes permissionless, around-the-clock on-chain trading possible without any central market maker.
The catch is a risk unique to this design called impermanent loss, where providers can end up worse off than if they had simply held the two tokens, especially when their prices diverge sharply. There is also smart-contract risk. The fees are real, but so are the risks, and Crypto House frames pools as mechanics rather than a guaranteed yield. The size of a pool matters too: a deep pool absorbs large trades with little price impact, while a shallow one can lurch sharply on even a modest swap.
DeFi Basics and Risks
Key takeaways
- A liquidity pool is a shared reserve of tokens in a smart contract that a DEX trades against instead of an order book.
- Liquidity providers deposit token pairs and earn a share of the swap fees traders pay.
- Providing liquidity carries impermanent loss and smart-contract risk, so returns are not guaranteed.
Liquidity Pool — preguntas frecuentes
How do liquidity providers earn money?
They collect a share of the fees traders pay on every swap against the pool, split in proportion to how much they deposited. Those fees are the incentive to lock up assets, though they must be weighed against the risks.
What is the main risk of providing liquidity?
Impermanent loss: when the two pooled tokens diverge in price, a provider can end up with less value than simply holding them would have given. Smart-contract bugs are an additional risk to consider.
Related terms
Automated Market Maker (AMM)Impermanent LossDecentralised Exchange (DEX)Yield FarmingTotal Value Locked (TVL) Todos los términos →New to crypto, or filling in the gaps? Work through the essentials in Learn, browse every term A–Z, or see live prices for the coins these concepts power.