{"id":37936,"date":"2023-10-23T13:00:00","date_gmt":"2023-10-23T10:00:00","guid":{"rendered":"https:\/\/forklog.com\/en\/?p=37936"},"modified":"2025-08-29T23:38:59","modified_gmt":"2025-08-29T20:38:59","slug":"what-are-liquidity-pools-and-how-do-they-work","status":"publish","type":"post","link":"https:\/\/forklog.com\/en\/what-are-liquidity-pools-and-how-do-they-work\/","title":{"rendered":"What are liquidity pools and how do they work?"},"content":{"rendered":"
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What is liquidity?<\/h2>\n

Liquidity<\/strong> is a foundational concept in both traditional and crypto markets. It describes the ability to sell assets quickly and smoothly at a price close to the market rate.<\/p>\n

Liquidity is usually provided by a large number of buyers and sellers. If a financial instrument is little traded and thus illiquid, converting it to cash may take time.<\/p>\n

A trade may also involve significant slippage<\/a>. This is the difference between the price at which a market participant intended to sell an asset and the price at which the trade was actually executed.<\/p>\n<\/div>\n

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What is a liquidity pool?<\/h2>\n

Liquidity pools are a key element of decentralised finance (DeFi). They are sets of cryptoassets locked in a smart contract<\/a>.<\/p>\n

Liquidity pools are used across the \u201cmoney Lego\u201d stack, spanning crypto lending, DEX<\/span>, decentralised insurance, synthetic assets, and more.<\/p>\n

An important component is the automated market maker (AMM)<\/a>. This algorithm features in most DeFi protocols. It manages liquidity and prices of cryptoassets on decentralised platforms, enabling automated trading.<\/p>\n<\/div>\n

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How does a liquidity pool work?<\/h2>\n

Anyone in the DeFi ecosystem can create a liquidity pool. To do so, an investor locks a pair of cryptoassets in a smart contract in equal value parts, setting initial prices.<\/p>\n

Users of AMM platforms who supply funds to pools are called liquidity providers (LPs). Prices are set by supply and demand (a coin\u2019s market value rises when many users buy it, and vice versa) and by the formula embedded in each platform\u2019s algorithm.<\/p>\n

For supplying assets, liquidity providers earn a share of trading fees. The size of this reward depends on the amount of liquidity contributed, represented by special cryptoassets\u2014LP tokens. These can be used across the \u201cmoney Lego\u201d ecosystem.<\/p>\n

\"lp-lp-tokens\"<\/figure>\n

The practice of earning passively by depositing cryptoassets on DeFi platforms is known as \u2018yield farming\u2019<\/a> or \u201cliquidity mining\u201d.<\/p>\n

Any market participant can trade the assets in a pool. There is no need for counterparties (buyers and sellers as on traditional platforms) or an order book\u2014the AMM executes trades directly against the pool.<\/p>\n

Most DEXs operate under the Constant Product Market Maker (CPMM) model. First introduced by Bancor, it rose to prominence with Uniswap<\/a>.<\/p>\n

Under CPMM, the product of the values of two assets in a pool is a constant:<\/p>\n

Token A * Token B = K<\/p>\n

where:<\/p>\n

Token A: value of Token A<\/p>\n

Token B: value of Token B<\/p>\n

K: constant<\/p>\n

The ratio between tokens in the pool dictates prices. For example, if someone buys ETH in a DAI\/ETH pair, the supply of ETH in the pool falls while DAI rises. As a result, the price of ether increases and the stablecoin\u2019s price falls. The impact on market prices depends on the trade size relative to the pool. If the pool\u2019s TVL<\/span> is large and the trade is only a few dollars, the price impact will be small.<\/p>\n

LPs can exit a liquidity pool at any time by redeeming their LP tokens. The participant immediately receives the originally deposited coins and the percentage income accrued from trading activity.<\/p>\n<\/div>\n

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Which DeFi platforms are built on liquidity pools?<\/h2>\n

Most DEXs rely on AMMs using the CPMM model. This type of exchange accounts for nearly 90% of the segment.<\/p>\n

\"DEX-Mech-Volume-Share\"
Data: CoinGecko, The Block<\/a>.<\/figcaption><\/figure>\n

The corresponding share for \u201chybrid\u201d DEXs is ~9.5%, and for order-book-based decentralised exchanges ~1%.<\/p>\n

Uniswap is the segment\u2019s perennial leader by TVL and trading volume<\/a>. At the time of writing (20 October 2023) the exchange supports eight networks, including Ethereum, Arbitrum<\/a>, Optimism<\/a>, Polygon<\/a>, Base<\/a>, BNB Chain, Avalanche<\/a> and Celo.<\/p>\n

\"Dexes-TVL-Ratings\"
DEX ranking by TVL. Data from DeFi Llama<\/a> as of 20.10.2023.<\/figcaption><\/figure>\n

In July, Uniswap Labs unveiled UniswapX\u2014an open-source protocol that aggregates liquidity from decentralised exchanges. In the same month, the developers set a launch window for Uniswap v4: within four months of Ethereum\u2019s Dencun hard fork.<\/p>\n

Curve is also popular among crypto traders. It is designed for efficient trading between stablecoins and other like-valued tokens with minimal slippage and fees.<\/p>\n

Balancer commands a sizeable market share too. The platform allows pools with three or more tokens.<\/p>\n

The table below shows types of liquidity pools and examples of platforms:<\/p>\n

\"tipy-razlichnyh-pulov-likvidnosti\"<\/figure>\n<\/div>\n
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What are the advantages of liquidity pools?<\/h2>\n

As a cornerstone of a fast-evolving DeFi ecosystem, liquidity pools let any market participant earn passive income on cryptoassets.<\/p>\n

Their most important attribute is being permissionless. This means any user can create a liquidity pool and, in effect, a new market. There are no review or approval processes\u2014everything happens in a decentralised, intermediary-free manner.<\/p>\n

Both large and small investors can take part\u2014the barrier to entry is minimal. Such openness fosters a more inclusive and equitable financial system, where anyone can add liquidity and help stimulate trading activity.<\/p>\n

DEXs run on open-source smart contracts, ensuring transparency and allowing external audits.<\/p>\n<\/div>\n

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What are the drawbacks of liquidity pools?<\/h2>\n

The DeFi ecosystem is still far from mature. Alongside clear advantages, its key building blocks have several drawbacks:<\/p>\n