What is a liquidity pool?
- Author
- CRYPTO PORT Editorial
- Published
- Updated
- Reading time
- 5 min
In short
A liquidity pool is a smart contract holding the assets that a DEX trades against. Depositors earn a share of swap fees, but as prices move the pool rebalances their holdings, and the outcome can end up worse than simply holding.
Key points
- The capital that trades execute against
- Depositors receive a share of swap fees
- Price moves automatically rebalance your position
- Carries its own risk: impermanent loss
Definition
Two or more assets deposited into a smart contract so that swaps can execute against them, with depositors receiving a token representing their share.
To supply an ETH/USDC pool you normally deposit equal value of each side. You receive a token representing your share and hand it back on withdrawal. Swap fees collected by the pool are split according to those shares.
The complication is what happens when prices move. If ETH rises, arbitrage drains ETH from the pool and adds USDC. On withdrawal you get less of the asset that appreciated and more of the one that did not — and end up with less value than if you had simply held. That gap is impermanent loss.
Fee income can outweigh the gap, but whether it does depends on volume and volatility and cannot be known in advance. Quoted 'APR' figures usually count only the fee side, so the price effect still has to be subtracted from them.
Watch out for
- · Advertised yields usually exclude the price-divergence effect entirely
- · A contract exploit can take the deposited assets themselves
- · In low-volume pools, fees may never cover the divergence