What Are Liquidity Pools?

Last updated August 30, 2021

Liquidity pools are almost certainly the biggest innovation to come out of DeFi and a great enabler of its growth because they allow DEXs to accumulate liquidity through funds locked up in a smart contract and enable automated market making without a centralized intermediary. A liquidity pool is basically just a term used for funds that are collected and locked up in a smart contract and they act as the backbone of most DEXs.

Liquidity providers (LPs) are users who lend liquidity to the pools by adding an equal amount of value of two tokens to create a market. In return for lending liquidity to the pool, LPs receive a percentage of the trading fees that take place in their pool that is proportional to the amount of liquidity they have provided.

Let's take a look at an example of a liquidity pool in action. Pool A is the ATOM<>CRO pool. LPs must deposit an equal amount of ATOM and CRO tokens and they will receive Pool A tokens in return (otherwise called LP tokens) that represent their share of their proportional ownership of the pool. In order to participate in pool A, users pay a transaction fee that is added to the pool assets and distributed to LPs. As the total liquidity of the pool increases, so does the LP's total contribution.

Bancor and Uniswap were the first exchanges to use liquidity pools but they have now become widely used across DeFi protocols. Liquidity pools are a popular way of earning yield on assets, however, they do have some drawbacks and risks associated with them, one of which is impermanent loss.