Liquidity pools are the foundation of decentralized trading. Instead of matching buyers with sellers (like a stock exchange), DeFi uses pools of money that anyone can trade against.
The Problem They Solve
On a normal exchange (Binance, NSE, NYSE), trading works through an order book. Buyers say “I’ll buy at ₹100”, sellers say “I’ll sell at ₹102”, and trades happen when prices match.
This needs a lot of active traders to work well. But on a decentralized blockchain, there’s no company maintaining an order book or matching trades. So DeFi said: forget order books. Use math instead.
How Liquidity Pools Work
Think of it with the friend group:
You and your friends want to exchange dollars and rupees anytime, without going to a bank. So 5 of you chip in and create a shared pot: $5,000 and â‚ą400,000. Now whenever anyone needs to swap, they trade against the pot instead of finding another person willing to trade.
flowchart TD subgraph pool["Liquidity Pool 🏊"] A["5,000 USDC"] --- B["2 ETH"] end C["You want ETH"] -->|"Deposit USDC"| pool pool -->|"Get ETH"| C D["Aman wants USDC"] -->|"Deposit ETH"| pool pool -->|"Get USDC"| D
No need to find a buyer or seller. The pool is always there, always ready to trade. 24/7, no holidays, no closing time.
Liquidity Providers (LPs)
The people who put money into the pool are called liquidity providers. Why would anyone lock their money in a pool?
Because they earn a fee from every trade. Most pools charge 0.3% per swap, and that fee goes to the liquidity providers proportional to how much they contributed.
It’s like investing in a currency exchange booth at an airport. You provide the cash reserves, and you get a cut of every transaction tourists make.
How Prices are Set
A formula called an Automated Market Maker (AMM) determines the exchange rate. The pool doesn’t use a fixed price — it calculates the rate mathematically based on how much of each token is in the pool. Read the automated-market-makers post for the full breakdown.
The Risks
Impermanent Loss
If the price of tokens in the pool changes significantly, you might end up with less value than if you’d just held the tokens. This is called impermanent-loss and it’s the biggest risk for LPs. Definitely read that post before providing liquidity.
Smart Contract Risk
The pool is a smart contract. If there’s a bug in the code, funds could be drained. This has happened before. Only use well-audited protocols.
Rug Pulls
On sketchy protocols, the creators might have a backdoor to drain the pool. Stick to established platforms.
Popular Platforms
- Uniswap — Biggest decentralized exchange (DEX), 0.3% fee per trade, shared among LPs
- Curve — Specialized for stablecoins (USDC/USDT/DAI), very low slippage
- Balancer — Allows pools with more than 2 tokens and custom ratios
- PancakeSwap — Biggest DEX on BNB chain (Binance’s chain)
What’s Next?
To understand HOW the pool calculates prices, read automated-market-makers. To understand the main risk of providing liquidity, read impermanent-loss.