What Is a Liquidity Pool? How It Works in DeFi
Decentralized exchanges have no usual order book; liquidity pools take its place. Here's how they work and what risks you take on when you deposit coins into one.
What it is
A liquidity pool is a smart contract that holds two tokens, for example ETH and USDC. Traders swap one for the other directly with the pool, and the price is set by a formula: the more of one token is taken out of the pool, the more expensive it becomes. This is how decentralized exchanges (DEXs) such as Uniswap work.
Who deposits the coins
Liquidity providers put both tokens into the pool in equal value. In return, they get a share of the fees from every swap. The more swaps, the more fees.
Risks
| Risk | What it is |
|---|---|
| Impermanent loss | The token prices diverged, and the result is worse than just holding the coins |
| Contract bug | If it's hacked, the money in the pool can disappear |
| Scam pool | The creators pull the liquidity: a rug pull |
| Token crash | If a token loses value, so does your share |
For swaps: small pools have high slippage, and you need to verify the token address because fakes are common. More in the article DeFi. For a beginner, it's easier to start with a major exchange: how to choose a crypto exchange.
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- A liquidity pool is a contract holding two tokens for swaps.
- Providers get a share of the fees, but they carry risks.
- The main risks are impermanent loss and contract bugs.
Frequently Asked Questions
What is impermanent loss?
It's the difference between the value of your coins in the pool and what they'd be worth if you had simply held them in your wallet. It appears when the prices of the two tokens diverge significantly.
Can I lose all my money in a pool?
Yes: if the contract is hacked, the creators run a scam, or one of the tokens crashes. Only deposit what you're prepared to lose.
How is a pool different from an exchange order book?
In an order book, the price is set by participants' orders. In a pool, it's set by a formula based on the ratio of the tokens, with no matching orders.
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