Liquidity Pool

A liquidity pool is a smart contract holding reserves of two or more tokens that traders can swap against, with prices set algorithmically by the pool's balance of assets. The tokens are deposited by users called liquidity providers, who earn a share of the trading fees generated by the pool in return. Pools are the core mechanism behind automated market makers and most decentralized exchanges.

A concrete example: an ETH/USDC pool on Uniswap might hold thousands of ETH and a matching value of USDC. When someone swaps USDC for ETH, the contract takes their USDC into the pool and pays out ETH from the reserves, adjusting the price according to the new ratio. A small fee — often a fraction of a percent — is taken from each trade and accrues to the providers.

A common misconception is that depositing into a pool is like a savings account; it is not, because the pool constantly rebalances your assets as prices move, exposing you to impermanent loss when the two tokens diverge in value. Pool depth matters too: a deep pool absorbs large trades with little price impact, while a shallow pool produces heavy slippage. Anyone can create a pool for any token pair, which enables open markets but also means some pools contain worthless or malicious tokens.