A liquidity pool is a reserve of cryptoassets locked in a smart contract and used by a DeFi protocol to facilitate financial operations. One of the most common applications is decentralized token trading, where a pool provides liquidity without requiring a traditional order book.

Users who deposit assets into a pool are called liquidity providers. Depending on the protocol, they receive a share of the pool and may earn a portion of transaction fees. The exact accounting mechanism differs between protocols.

For example, a pool can contain Token A and Token B. A trader exchanging Token A for Token B interacts with the pool contract. The transaction increases the reserve of Token A and decreases the reserve of Token B according to the pool formula and the amount being traded.

Pool size has a major effect on trading quality. A large amount of liquidity relative to the trade size generally reduces the price impact of a transaction. A small pool can experience significant reserve changes from a large trade, resulting in higher slippage.

Liquidity pools are not limited to token swaps. They can also be used as components of lending markets, derivatives, yield strategies, and other financial applications. In lending systems, for example, deposited assets can form a shared reserve from which borrowers obtain liquidity.

Liquidity providers take on several risks. One of the most important is impermanent loss, which can occur when the relative prices of pool assets change. Smart-contract vulnerabilities, oracle failures, liquidity shortages, and protocol-specific economic risks also need to be considered.

Important liquidity-pool metrics

  • Reserves — amounts of each asset held by the pool.
  • Trading volume — value or quantity of trades executed through the pool.
  • Fees — charges collected from users and potentially distributed to liquidity providers.
  • Liquidity share — the provider share of the pool.
  • Price impact — the effect of a trade on the effective execution price.