What Are Liquidity Pools?

Liquidity Pools

Liquidity pools (LPs) are like pools of money that sit on decentralized exchanges (DEXs). When someone wants to trade, they put tokens into a pool and withdraw the tokens they want.

LPs mostly contain two tokens making up a trading pair. A DEX usually has many pools, one for each pair.

The ratio of tokens in each pool must always add up to the same value and this is maintained by an automated market maker, an algorithm that automatically balances the ratio of tokens. When someone uses an LP, they are charged a small fee, a portion of which is paid to people who “loan” liquidity to the pool.

Anyone can provide liquidity to an LP and earn fees. Most of the time you need to provide both sides of the trading pair in equal value so the ratio is maintained. In return, you receive “LP tokens” which are like receipts showing your share of the overall pool. These tokens can then be staked for additional rewards.

The process of providing and withdrawing liquidity is governed by smart contracts that track how much of the pool is owned by each wallet and provide that portion back upon request. This allows the process of market making to be fully automated and decentralized.

LPs are also used in other ways too. For example, users can pool governance tokens together to create a voting bloc and influence a protocol’s governance process. Also, in the case of decentralized index funds, liquidity pools back the price of an index.

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