Liquidity pools power decentralized trading. Here's how they work and how to earn from them.
What is a Liquidity Pool?
A liquidity pool is a collection of funds locked in a smart contract. These funds enable decentralized trading without traditional order books.
How AMMs Work
Automated Market Makers (AMMs) use mathematical formulas to price assets. The most common is x*y=k (constant product).
When traders swap, they pay a fee (usually 0.3%) that goes to liquidity providers.
Providing Liquidity
- Choose a DEX (Uniswap, SushiSwap, etc.)
- Select a trading pair (e.g., ETH/USDC)
- Deposit equal value of both tokens
- Receive LP tokens representing your share
- Earn fees proportional to your share
Understanding Impermanent Loss
When prices change, LPs may have less value than simply holding. This 'impermanent loss' becomes permanent when you withdraw.
- More volatile pairs = higher IL risk
- Stablecoin pairs have minimal IL
- Fees can offset IL in high-volume pools