Liquidity pools are the foundation of automated market makers, a model used by many decentralised exchanges. Instead of matching individual buyers with sellers, trades are executed against a shared pool of tokens, with prices set by a formula based on the ratio of assets in the pool. Anyone can typically become a liquidity provider by depositing an equivalent value of each asset in a trading pair, and in return they earn a share of the trading fees generated by that pool.
In exchange for their deposit, liquidity providers usually receive a receipt token representing their share of the pool, which can later be redeemed for their portion of the underlying assets plus any fees earned. Liquidity pools are not limited to trading; similar pooled structures are used in lending markets and other decentralised finance applications.
Providing liquidity carries real risks. If the price of the two pooled assets diverges significantly, a liquidity provider can end up with less value than if they had simply held the assets separately, a risk known as impermanent loss. Pools also depend entirely on the underlying smart contract being secure, so a flaw in that code can put deposited funds at risk. Fees earned over time can offset impermanent loss to some degree, but the overall outcome depends heavily on how much the pooled assets move relative to each other and how long liquidity is left in the pool.
Key takeaways
- Liquidity pools let trading happen against pooled funds and an algorithm, instead of a matched buyer and seller.
- Liquidity providers earn a share of trading fees in return for depositing assets into the pool.
- Providing liquidity carries risks, including impermanent loss and exposure to bugs in the underlying smart contract.
Liquidity Pool — frequently asked questions
What is impermanent loss?
It is the gap that can open up between holding two assets in a liquidity pool versus simply holding them in a wallet, caused by how the pool automatically rebalances as prices move. It becomes a permanent loss only if the provider withdraws while that gap exists.
Do liquidity providers always earn a profit?
Not necessarily. Fee income can be offset or exceeded by impermanent loss, particularly in pools with volatile assets, so returns depend on trading volume, fee levels, and how much the pooled assets move relative to each other.
Related terms
Automated Market Maker (AMM)Decentralised Exchange (DEX)Impermanent LossDeFiLiquidity All terms →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.