What Is a Liquidity Pool?
A liquidity pool is a collection of digital assets locked in a smart contract that enables users to trade, borrow, and lend without relying on traditional buyers or sellers. In decentralized finance (DeFi), liquidity pools replace order books by using automated market makers (AMMs). Users called liquidity providers supply pairs of tokens to these pools and in return earn fees generated by trades.
When traders interact with a liquidity pool, they swap one asset for another directly through the pool. Prices are determined by the ratio of tokens in the pool and algorithmic formulas rather than human negotiation. Liquidity pools improve market liquidity, meaning trades can happen quickly with less price impact.
Providing liquidity carries rewards in the form of trading fees, but also risks such as impermanent loss, where changes in token prices can reduce a provider’s effective earnings relative to simply holding assets.
Liquidity pools are fundamental to many DeFi protocols and play a key role in how decentralized exchanges and financial products operate onchain.
