Liquidity pool
Also called: LP · pool
Definition
A liquidity pool is a smart contract holding two or more tokens that traders swap against on a DEX, funded by liquidity providers who earn a share of the trading fees.
How liquidity pool works
When you add liquidity, you usually deposit both tokens of a pair in the current price ratio, for example ETH and USDC. In return you get LP tokens or an NFT position that represents your share of the pool. When you withdraw, you receive your share of whatever is in the pool at that time, plus fees earned.
Your earnings come from trading fees, sometimes topped up by token rewards. Your risks include impermanent loss when prices move, smart contract bugs, and for new tokens, the chance that the token itself collapses or is a rug pull.
Pool depth matters to traders too. The more value in a pool, the smaller the price impact of each trade. That is why total liquidity is one of the first numbers to check before buying a small token on a DEX.
Example
Say a pool holds 500,000 USDC and 200 ETH, at 2,500 USDC per ETH, for a total of 1,000,000 USDC. You add 5,000 USDC and 2 ETH, which equals 1 percent of the pool. Over a month, traders pay 30,000 USDC in fees to the pool. Your 1 percent share earns about 300 USDC, before any impermanent loss and gas costs.
Common mistakes
- Looking only at the advertised APR and ignoring impermanent loss and token risk.
- Providing liquidity for a token whose pool liquidity is controlled by the team.
- Losing or transferring the LP tokens that represent your position.
Learn and practise
FAQ
How do liquidity pools make money?
They collect a fee on every swap, which is shared among liquidity providers in proportion to their share of the pool.
Can I lose money in a liquidity pool?
Yes. Price moves cause impermanent loss, and a smart contract bug or token collapse can cause larger losses.