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How Liquidity Pools Work

A beginner-friendly look at how crypto liquidity pools function, generate returns and what could go wrong.

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Whether you’re staking, swapping or yield farming, liquidity pools are a big part of how decentralized finance (DeFi) works behind the scenes.

If you’re a crypto investor curious about earning passive income or maximizing the value of your holdings, learning how these pools operate is an important step toward making informed choices.

What are liquidity pools?

Liquidity pools are essentially crowdsourced collections of crypto assets locked in a smart contract.(1) They are used to facilitate decentralized trading, lending and other DeFi functions without needing a traditional order book or centralized market maker.

Instead of buyers and sellers matching orders, users trade directly against the pool, which automatically adjusts prices based on supply and demand. These pools are the backbone of decentralized exchanges (DEXs), the likes of Uniswap and Curve, and allow for real-time transactions while rewarding users who supply the tokens.

How do liquidity pools work?

A liquidity pool allows users to deposit two different crypto tokens into a “shared pot” of funds. These shared pools allow other users to trade those tokens directly through the pool instead of with a counterparty.

Within the liquidity pool, a built-in algorithm is leveraged for pricing, which figures out how much of each token is exchanged during a trade. Depending on the ratio of tokens left within the liquidity pool, the price updates automatically.

Token pairs and equal value

A vast majority of liquidity pools require users to deposit two tokens of equal dollar value. So, for example, if you want to join a USDC/ETH pool, you’d put in $500 worth of each. At the time of writing, this would be roughly 500 USD Coin and 0.205 ethereum.

Having things set up this way ensures fair pricing and helps keep the pool running as smoothly as possible as people trade in and out. If the values shift too far apart, it can affect how much you get back later, especially during volatile markets.

Automated market maker (AMM) model

With a traditional order book system, buyers and sellers place bids and asks, and then a matching engine pairs them up.(2) With liquidity pools, a key difference is in effect — there’s no need for a counterparty to execute a trade.

Whereas centralized exchanges require another user to agree to your price, which can cause delays or slippage, liquidity pools use automated market makers. These algorithms calculate prices in real time based on the proportion of tokens left within the pool. Trading happens instantaneously, and there’s no need for a centralized actor, such as an exchange, to coordinate supply and demand.

Earning fees

So, why would anyone deposit tokens into a liquidity pool? It’s quite simple. Liquidity providers earn a portion of the fees that are generated from the trading activity of the wider pool.

The exact extent of these earned fees, of course, will depend on how much liquidity a particular user is contributing. Moreover, several platforms offer further incentives through bonus tokens.

Price shifts and arbitrage

Each time someone trades, it changes the amount of tokens in the pool, which also shifts the price. If the pool’s price starts to differ from the broader market, arbitrage traders step in.

They buy from the cheaper source and sell to the more expensive one, pocketing the difference. While at first glance, this might seem like merely a method for traders to profit, in the grand scheme of things, arbitrage also maintains market efficiency, as it helps realign pool prices with those of the overall market.

Several decentralized platforms allow users to contribute assets to liquidity pools and earn a share of fees or rewards. Here are some of the most widely used:

  • AAVE. While best known for lending and borrowing, AAVE also uses liquidity pools to enable flash loans and deposit-based earnings. Liquidity providers earn interest from borrowers and may receive AAVE token incentives.
  • Uniswap. One of the largest DEXs, Uniswap pioneered the AMM model. Users can supply token pairs to thousands of pools and earn a cut of 0.3% swap fees.
  • Balancer. Balancer supports multi-token pools with flexible weightings (not just 50/50). It’s popular for portfolio-style exposure and automatic rebalancing features.
  • Curve Finance. Optimized for stablecoins, Curve offers low-slippage trading between assets like USDC, DAI and USDT. The platform attracts both high-volume traders and liquidity providers in search of stable returns.
  • SushiSwap. A fork of Uniswap, SushiSwap offers similar features with added incentives like yield farming and staking. The platform’s community-run model has since expanded to include other features, such as lending and token launchpads.
  • PancakeSwap. The leading DEX on BNB Chain, PancakeSwap provides low-fee token swaps and yield farming. It appeals to retail users with gamified staking, lotteries and a wide range of token pairs.

Who uses liquidity pools?

Liquidity pools serve a wide range of users in the decentralized finance ecosystem, from everyday traders to protocol-level participants. Here are some of the main user types:

  • Decentralized exchanges. DEXs like Uniswap or PancakeSwap rely on liquidity pools to enable token swaps without centralized order books.
  • Liquidity providers. Users who deposit token pairs into pools to earn a share of trading fees or yield rewards. Anyone with compatible tokens and a wallet can become a provider.
  • Arbitrage traders. These traders monitor price differences across platforms and use liquidity pools to profit from inefficiencies, helping stabilize prices in the process.
  • Protocol developers. Some DeFi projects bootstrap early liquidity by creating pools for their native tokens. This helps kickstart trading activity and incentivizes ecosystem growth.

Benefits of liquidity pools

Liquidity pools play an important role in maintaining market efficiency and seamless trading, but they also provide a handy way for crypto investors to earn passive income. Before we move on to some of the potential risks associated with liquidity pools, let’s look at the key benefits they provide:

  • Decentralized trading. The use of liquidity pools eliminates the need for centralized intermediaries. This allows users to swap tokens directly on-chain, which makes DeFi protocols more accessible and transparent.
  • High APYs. Some pools offer very attractive yields — especially during periods of high trading volume or when paired with reward incentives like governance tokens. Early adopters or providers in new pools often earn the highest returns.
  • Passive income potential. Liquidity providers can earn a share of trading fees without actively managing their positions. It’s a way to put idle crypto holdings to work while participating in the broader DeFi economy.
  • Improved market efficiency. Last but not least, pools provide constant liquidity, reducing slippage and increasing trading efficiency — even for low-volume tokens. This accessibility makes it easier to launch and trade new digital assets without needing an exchange listing.

Risks of liquidity pools

Just like any opportunity in DeFi, liquidity pools come with tradeoffs. While the potential for returns is real, there are also several risks that liquidity providers should consider before getting involved:

  • Impermanent loss. This occurs when the value of tokens inside a pool diverges significantly compared to simply holding them. The more volatile the token pair, the greater the risk that you’ll withdraw less value than you put in.
  • Smart contracts risk. Liquidity pools are governed by smart contracts, which can have bugs or be exploited. If a contract is hacked, funds in the pool may be drained with little recourse for providers.
  • Rug pulls and exit scams. Rug pulls and exit scams — in less reputable or unaudited pools, developers may create a pool, attract deposits and then withdraw the funds — leaving providers with tokens that essentially become an illiquid asset.(3) This is especially risky on newer or low-volume platforms.
  • Regulatory uncertainty. Although significant progress has been made, DeFi remains a gray area in many jurisdictions. Future regulations could impact how pools operate or affect user access, particularly for US-based investors.

Bottom line

Liquidity pools power a wide range of DeFi activity and can offer meaningful rewards — but not without risk. If you’re exploring this strategy, take the time to understand how pools work, what can go wrong and whether the potential returns align with your broader goals. Ready to dive in? Compare crypto wallets to get started.

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To make sure you get accurate and helpful information, this guide has been edited by Holly Jennings as part of our fact-checking process.
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Contributor

Shane's career started with the US Department of Defense where he performed research for 8 years. He then studied philosophy and became fascinated by the ways in which technology and finance can consolidate to impact the world's socio-economic order. To date, he has written hundreds of articles with various insights into digital assets, trading, investing, and the ways in which technology can be used to further optimize the stock trading and settlement processes. His work has been featured in Yahoo Finance, Nasdaq, Bitcoin Magazine, Investing.com, Tokenist, and others. See full bio

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