A liquidity pool is a collection of tokens locked in a smart contract that powers a decentralised exchange or lending protocol. Instead of matching individual buyers and sellers, traders swap against the pool, and the pool automatically adjusts the price based on how much of each token it holds.
Users who deposit tokens into a pool become liquidity providers and earn a share of the trading fees generated by every swap. In some protocols they also earn additional token rewards, which is the basis of yield farming.
The risk for liquidity providers is impermanent loss: if the relative price of the two tokens in the pool shifts significantly, the provider ends up with less value than if they had simply held the tokens. Understanding this trade-off between fee income and impermanent loss is the core literacy needed before providing liquidity.
Worked example
A 50/50 ETH/USDC pool lets traders swap between the two; each swap pays a small fee that accumulates for the pool's liquidity providers.
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This definition is general education, not investment advice. Markets — especially crypto — are volatile and you can lose money. Please read our disclaimer and see our methodology.