Liquidity Pool
In plain English
A pot of two or more tokens locked in a smart contract that traders swap against. Depositors earn a share of the fees — and take on impermanent loss.
What is a liquidity pool?
A liquidity pool is a smart contract holding reserves of two or more tokens, against which anyone can trade. It replaces the traditional order book: instead of matching a buyer with a seller, a trade happens directly against the pool, with the price set by a formula based on the ratio of assets inside it.
How pricing works
Most pools use a constant-product formula: multiply the quantity of one token by the quantity of the other, and keep that product unchanged after each trade. Buying token A removes it from the pool and adds token B, which makes the remaining A more expensive. The market therefore prices itself automatically, without anyone quoting an order.
Large trades relative to pool size move the price significantly — this is slippage, and it is why deep pools give better execution.
Who supplies the tokens
Liquidity providers deposit both assets in the required ratio and receive LP tokens representing their share. In exchange they earn a cut of every swap fee, typically a fraction of a percent per trade, proportional to their share of the pool.
Impermanent loss
This is the crucial risk and the one most often misunderstood. When the price of the pooled assets diverges, the pool automatically rebalances by selling the rising asset and accumulating the falling one. The result is that you end up with less value than if you had simply held both tokens in your wallet.
The loss is called "impermanent" because it reverses if prices return to their original ratio — but if you withdraw while they have diverged, it becomes permanent. Fee income can offset it, and often does in stable pairs; in volatile pairs it frequently does not.