Liquidity Pool
A liquidity pool is a stock of two or more tokens locked in a smart contract that people trade against on a decentralized exchange. Instead of matching buyers with sellers, the pool itself is the counterparty and a formula sets the price.
How a pool sets prices
Many decentralized exchanges use an automated market maker (AMM). The best-known formula, introduced by Uniswap, keeps the product of the two token balances constant: x × y = k. When you buy one token from the pool, you add the other, and the ratio between the two balances changes, which moves the price.
Arbitrage traders keep pool prices close to the wider market: if a pool's price drifts from other venues, they trade against it until the gap closes.
An example
Say a pool holds 10 ETH and 20,000 USDC, so the price is 2,000 USDC per ETH. You want 1 ETH. To keep the product constant, the pool needs about 22,222 USDC once only 9 ETH remain, so you pay about 2,222 USDC plus the trading fee. That gap between the quoted price and what you pay is slippage, and it is large here because the pool is small. In a pool a thousand times bigger, the same trade would barely move the price.
Who supplies the tokens
Anyone can deposit tokens into a pool and become a liquidity provider. In return they receive a share of the trading fees, usually tracked by LP tokens that represent their portion of the pool. Deeper pools mean lower slippage, which attracts more trading and more fees.
Risks
For traders, small pools mean high slippage and easy manipulation, and many scam tokens trade only in pools the creator can drain, the classic rug pull. For depositors, the main risk is impermanent loss: when prices move, the pool automatically sells the rising token and buys the falling one, so you can end up worse off than if you had simply held. Smart-contract bugs can also put the whole pool at risk.
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Frequently asked questions
Why do decentralized exchanges use liquidity pools?
Order books need many active market makers and frequent on-chain updates, which is expensive on a blockchain. A pool with a pricing formula lets anyone trade at any time.
What are LP tokens?
Tokens you receive when you deposit into a pool. They represent your share of the pool and are needed to withdraw your tokens and earned fees later.
Can a liquidity pool run out?
Not completely with the x × y = k formula, because the price rises without limit as one side shrinks. In practice, a small pool becomes so expensive to trade that it is effectively unusable.
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