Liquidity pools are smart contracts holding token pairs that enable decentralized trading. When you provide liquidity, you deposit tokens and receive LP tokens representing your share. This guide explains the mechanics, risks, and rewards of liquidity providing.
What is a Liquidity Pool?
A liquidity pool is a smart contract containing two (or more) tokens locked together:
- Token Reserves — The actual tokens in the pool
- LP Tokens — Receipts for liquidity providers
- Fee Accumulation — Trading fees added to the pool
Providing Liquidity: Step by Step
- Select a pool (e.g., ETH/USDC)
- Deposit both tokens in equal value
- Receive LP tokens proportional to your share
- Earn fees from every trade in the pool
- Withdraw anytime by burning LP tokens
LP Token Mechanics
LP tokens represent your proportional share of the pool:
- Pool has 100 ETH + 200,000 USDC
- You deposit 1 ETH + 2,000 USDC
- You own 1% of the pool
- As fees accumulate, your share grows in value
Earning Potential
| Factor | Impact on Returns |
|---|---|
| Trading Volume | Higher volume = more fees |
| Fee Tier | Higher fee = more per trade |
| Pool Size | Smaller pool = larger share |
| Price Movement | Stable = less impermanent loss |
Key Takeaways
- Liquidity pools enable permissionless, 24/7 trading
- LP tokens represent your share of the pool
- Fees accumulate automatically in the pool
- Returns depend on volume, fees, and price stability
- Impermanent loss is the key risk to understand