A liquidity pool is a collection of funds locked in a smart contract that allows people to trade tokens without a traditional order book. Instead of matching individual buyers and sellers, trades happen against the pool, which always has tokens available on both sides.
The funds in a pool are supplied by users known as liquidity providers, who deposit a pair of tokens. In return, they may earn a share of the fees from trades that use the pool. This is a core building block of decentralized exchanges and much of DeFi.
Providing liquidity carries real risks, not just potential rewards. Prices can move in ways that reduce the value of a deposit compared with simply holding, an effect called impermanent loss, and smart contracts themselves can have flaws. This entry explains the concept; it is not advice to provide liquidity.
Frequently Asked Questions
How do liquidity providers earn from a pool?
They may receive a share of the trading fees generated when people use the pool. This is a potential reward, not a guarantee, and it comes with risks like impermanent loss.
Is providing liquidity risk-free?
No. It carries real risks, including impermanent loss, where the value of a deposit can fall relative to simply holding, and the possibility of flaws in the smart contract.
