Crypto glossary
Liquidity pool
A liquidity pool is a reserve of tokens locked in a smart contract that traders swap against, funded by users who earn a share of the trading fees.
Liquidity pools are the inventory behind decentralized exchanges. Instead of matching a buyer with a seller, an automated market maker lets traders swap directly against tokens held in the pool, and a formula sets the price based on the ratio of the reserves.
Anyone can become a liquidity provider by depositing the required tokens, typically in equal value for a two-token pool such as ETH/USDC. In return the provider receives LP tokens or a position NFT representing their share, and earns a cut of every trade's fee. Some protocols add token rewards on top to attract deposits.
Deeper pools mean lower slippage for traders. For providers, the risks include impermanent loss when prices move, smart contract bugs and the chance that one token in the pair loses its value, leaving the pool full of the worthless asset as traders drain the good one.
Example
If you add $1,000 to an ETH/USDC pool that holds $10 million in total, you own 0.01% of it and collect 0.01% of the fees paid by every swap through that pool.
Related terms
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