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Liquidity pool

A liquidity pool is a shared supply of crypto and tokens made available for trading. This supply makes it possible to swap cryptocurrencies automatically on a decentralized exchange, without needing another buyer or seller at that moment.

Last updated • 2 min read
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What is a liquidity pool?

A liquidity pool is created when users make their crypto available through a smart contract. This is a program on the blockchain that automatically carries out transactions according to preset rules. The collected cryptocurrencies together form the pool.

Many decentralized exchanges (DEXs) use liquidity pools instead of a traditional order book. Users don't trade directly with other buyers or sellers. Instead, they swap their crypto through the pool. An automated system, also called an Automated Market Maker (AMM), calculates the price based on the number of tokens in the pool.

When someone swaps tokens, the balance of cryptocurrencies in the pool changes. This can also change the price. The smaller the pool is relative to the transaction, the greater the transaction's effect on the price tends to be.

An example of a liquidity pool

Imagine a liquidity pool on a decentralized exchange that contains Ethereum (ETH) and USDC. You want to swap USDC for ETH. You send USDC to the pool and receive ETH from that same pool.

After this transaction, the pool contains more USDC and less ETH. This changes the balance between the two cryptocurrencies, and a new price is automatically calculated for the next transaction.

This lets you swap crypto without someone else having to be ready at that moment to buy your USDC or sell you ETH.

Why are liquidity pools important in crypto?

Liquidity pools play an important role in DeFi (decentralized finance). They make it possible to trade cryptocurrencies on decentralized exchanges without traditional intermediaries. The more liquidity a pool has, the easier it is generally for users to trade larger amounts without significantly affecting the price.

Users who make their crypto available to a pool are called liquidity providers. In return, they may receive a share of the trading fees. Some platforms also offer extra rewards, for example through yield farming.

That's why you regularly read about liquidity pools in crypto news, especially in stories about DeFi, new tokens, and decentralized exchanges. A large amount of liquidity can, for example, make a token easier to trade, while a drop in liquidity can lead to sharp price swings.

Making crypto available to a liquidity pool also comes with risks. Price changes could leave you with less value than if you had held the tokens yourself. This is called impermanent loss. In addition, smart contract errors, hacks, and other security issues can lead to losses.

Disclaimer: This content is for informational purposes only and does not constitute financial, investment, legal, or tax advice. The information provided may be incomplete, inaccurate, or outdated and should not be relied upon as such. Nothing on this website should be considered a recommendation to buy, sell, or hold any cryptocurrency. Investing in crypto-assets involves risk of loss.