Liquidity Pools Explained
Liquidity pools are the backbone of decentralized exchanges. Instead of order books, DEXs use pools of tokens that anyone can trade against.
What is a Liquidity Pool?
A liquidity pool is:
- A smart contract holding two (or more) tokens
- Anyone can trade against the pool
- Prices determined by mathematical formula
- Liquidity providers (LPs) earn fees from trades
How AMMs Work
Automated Market Makers (AMMs) use the constant product formula:
- x * y = k (where k stays constant)
- As you buy token A, its price increases
- As you sell token A, its price decreases
- No order books, no matching buyers/sellers
Example
Pool has 10 ETH and 30,000 USDC (k = 300,000). To buy 1 ETH, you need to add enough USDC to maintain k. The more you buy, the higher the price.
Providing Liquidity
How to Add Liquidity
- Choose a pool (e.g., ETH/USDC)
- Deposit equal value of both tokens
- Receive LP tokens representing your share
- LP tokens earn portion of trading fees
Earning Fees
- Standard fee: 0.3% per trade (Uniswap v2)
- Fees distributed proportionally to LPs
- High volume pools = more fees
- Fees compound automatically into position
LP Token Mathematics
| You Deposit | Your Share | You Earn |
|---|---|---|
| $10,000 into $1M pool | 1% | 1% of all fees |
| $10,000 into $100K pool | 10% | 10% of all fees |
Pool Size Tradeoff
Smaller pools = higher share of fees but more impermanent loss risk and slippage. Larger pools = lower share but more stable.
Types of Pools
Standard Pools (50/50)
- Equal value of both tokens
- Used by Uniswap v2, SushiSwap
- Simple but subject to impermanent loss
Concentrated Liquidity (Uniswap v3)
- Provide liquidity in specific price ranges
- Higher capital efficiency
- More complex management required
Stable Pools
- Optimized for similar-priced assets
- Used by Curve for stablecoins
- Lower fees, lower impermanent loss
Impermanent Loss
The key risk of providing liquidity:
- Occurs when token prices diverge from when you deposited
- Called "impermanent" because it can reverse if prices return
- Becomes permanent when you withdraw
Impermanent Loss Example
Deposit $1000 ETH + $1000 USDC. ETH price doubles. If you held, you'd have $3000. In pool, you have ~$2450. That's 18% impermanent loss.
Popular LP Platforms
- Uniswap - Largest DEX, Ethereum + L2s
- Curve - Best for stablecoins
- Balancer - Custom pool ratios
- PancakeSwap - BNB Chain
- Raydium - Solana
LP Strategy Tips
- Start with stable pairs (USDC/USDT) to learn
- High volume = more fees to offset IL
- Monitor positions regularly
- Calculate if fees exceed impermanent loss
- Consider IL before choosing pairs
Withdrawing Liquidity
- Return LP tokens to the pool
- Receive your share of both tokens
- Ratio may differ from deposit (due to trades)
- Fees earned are included automatically