Liquidity pool
Liquidity pool: A liquidity pool is a smart contract that holds reserves of two or more tokens so traders can swap against the pool instead of waiting for another person’s order. Liquidity providers deposit tokens into the pool and usually earn a share of trading fees. Pools power most decentralised exchanges that use an automated market maker.
How a liquidity pool works
On an automated market maker, the pool’s balances and a pricing formula set the swap rate. When someone buys token A with token B, the pool’s reserves shift and the price moves along the curve. Ethereum’s DeFi documentation describes these pools as the inventory that lets users trade without a traditional order book of bids and asks.
What liquidity providers do
A liquidity provider deposits the required tokens, often in a set ratio, and receives LP tokens or an equivalent position that represents their share of the pool. As traders pay fees, that share can grow. When the provider withdraws, they redeem against the current reserves, which may differ in mix and value from what they put in.
Risks inside a pool
Token prices can diverge so your withdrawn mix is worth less than if you had held the tokens outside the pool, often called impermanent loss. A buggy or malicious pool contract can lose deposits. Thin pools create high slippage for traders and volatile returns for providers. Some pools include unstable or unaudited tokens that can go to zero.
Pools vs order books
Centralised exchanges usually match buyers and sellers on an order book with market makers posting bids and asks. A liquidity pool replaces that matching with reserves and a formula, which is why you can swap from a self-custody wallet at any time the chain is running. Our Guide to Uniswap walks through one widely used pool-based exchange design.
Frequently asked questions
What is an LP token?
A token or position that represents your share of a liquidity pool. You return it to the pool contract when you withdraw your portion of the reserves.
Do liquidity pools only hold two tokens?
Two-token pools are common, but some designs hold more than two assets or concentrate liquidity in a price range. Always read the specific pool’s rules.
Who earns the trading fees?
Usually the liquidity providers, in proportion to their share of the pool, after any protocol fee cut set by governance.