A smart-contract-locked reserve of two or more tokens that enables automated market-making on a DEX, providing liquidity for traders in exchange for a share of trading fees.
Liquidity pools are the engine of automated market maker (AMM) DEXes. Instead of matching buyers with sellers via an order book, AMMs use the ratio of tokens in a pool to determine price algorithmically. The constant product formula (x × y = k) used by Uniswap V2 ensures that as one token is bought, its price rises continuously - providing infinite liquidity at increasingly unfavourable rates.
Liquidity providers (LPs) deposit equal values of both tokens and receive LP tokens representing their share of the pool. They earn a proportional share of every trading fee charged against their pool. On Uniswap V3, concentrated liquidity allows LPs to specify a price range for their liquidity, achieving higher capital efficiency but requiring more active management.
The key risk for liquidity providers is impermanent loss: when the price of one token moves significantly relative to the other, the LP ends up holding more of the token that depreciated and less of the one that appreciated compared to simply holding both tokens. The 'loss' is impermanent because it reverses if prices return to the original ratio, but becomes permanent if liquidity is withdrawn at the diverged price. High-fee pools and pools of correlated assets (stablecoin pairs, liquid staking token pairs) minimise this risk.
Worked Example
An LP deposits USD 1,000 of ETH and USD 1,000 of USDC into a Uniswap pool (ETH at USD 2,000). If ETH doubles to USD 4,000, the pool rebalances and the LP ends up with roughly USD 2,828 total - versus USD 3,000 from simply holding. The USD 172 difference is impermanent loss, partially offset by accumulated trading fees.