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Learn how liquidity pools work in DeFi, how AMMs set prices, how to provide liquidity, and what risks and rewards are involved in 2026.
What Are Liquidity Pools? The Engine of DeFi Trading
A liquidity pool is a smart contract holding reserves of two or more tokens that enables trading without a traditional order book or counterparty. When you swap ETH for USDC on Uniswap, you are not matched with another person who wants to sell USDC. You are trading against a pool of ETH and USDC that was deposited by liquidity providers.
This model, called an Automated Market Maker (AMM), was pioneered by Uniswap in 2018 and has since become the dominant trading infrastructure across DeFi. Instead of buyers and sellers finding each other, a mathematical formula determines the exchange rate based on the current ratio of tokens in the pool.
Liquidity pools make decentralized trading possible because they provide continuous liquidity for any asset that has a pool, without requiring an active market maker to be present at all times.
How AMM Pricing Works: The Constant Product Formula
The most common AMM pricing formula is x times y equals k, where x and y are the quantities of the two tokens in the pool, and k is a constant.
When you buy token A from a pool, you remove some A and add some B. The formula requires that the product of the two quantities remains constant. To maintain this, the price of A increases as its supply in the pool decreases. This means every trade moves the price slightly, and larger trades move it more.
For example, a pool with 100 ETH and 300,000 USDC has a starting ETH price of $3,000. If you buy 10 ETH, you must deposit enough USDC to bring the product back to its constant. The price you pay for those 10 ETH will be higher than $3,000 per ETH because the pool is being depleted of ETH as you buy.
This is why pool size matters so much: larger pools mean any individual trade represents a smaller percentage of the total, resulting in less price impact and lower slippage.
Providing Liquidity: How It Works and What You Earn
Anyone can become a liquidity provider by depositing equal dollar values of both tokens in a pool. In return, you receive LP tokens representing your proportional share of the pool.
Every time someone trades through the pool, a fee, typically between 0.05 and 1 percent depending on the pool tier, is distributed proportionally to all liquidity providers. The more activity a pool sees, the more fees LPs earn.
When you withdraw liquidity, you redeem your LP tokens for your share of the pool. The amounts of each token you receive depend on the current ratio in the pool, which will have shifted based on trading activity since you deposited. This is the source of impermanent loss, covered in the next article.
Concentrated Liquidity: Uniswap V3 and Capital Efficiency
Traditional AMMs spread liquidity evenly across all possible prices from zero to infinity. This is capital inefficient because most trading happens within a narrow price range, leaving the vast majority of deposited capital idle.
Uniswap V3, launched in 2021, introduced concentrated liquidity, allowing LPs to specify the price range within which their capital is deployed. An LP might provide liquidity only between $2,800 and $3,200 for ETH, concentrating their capital where most trading occurs and earning far more fees per dollar deposited than in a traditional pool.
The tradeoff is increased complexity and management. If ETH's price moves outside your specified range, your liquidity becomes entirely one-sided and earns no fees until the price returns. Active LP management, adjusting ranges as prices move, has become a specialized DeFi activity in itself.
Choosing Which Pools to Provide Liquidity In
Not all pools are equally attractive for liquidity providers. Several factors determine whether a pool is likely to generate good returns.
Volume relative to TVL is the most important indicator of fee generation potential. A pool with $10 million TVL and $5 million daily volume will distribute fees far more generously than one with $50 million TVL and $1 million daily volume.
Token volatility affects impermanent loss exposure. Stable pairs like USDC and USDT experience minimal impermanent loss and are popular for conservative LPs. Volatile pairs like ETH and a small-cap token can generate high fees but expose providers to significant impermanent loss if prices diverge.
Additional token incentives, liquidity mining rewards paid in a protocol's governance token, can boost returns substantially but require evaluating the value and sustainability of those additional tokens.
Liquidity Pools: Core Infrastructure and Active Opportunity
Liquidity pools are the foundation of decentralized trading. Without them, DEXs could not function, DeFi would not exist at its current scale, and the permissionless, self-custody model of decentralized finance would be impossible.
For participants, providing liquidity is a way to put idle assets to work generating fees. The returns can be attractive, particularly in high-volume pools or with additional incentives, but they come with tradeoffs around impermanent loss, smart contract risk, and the active management that concentrated liquidity positions sometimes require.
Start with stable pairs and well-established protocols if you want to explore LP positions. Understand impermanent loss thoroughly before providing liquidity in volatile pairs.
This information, including any opinions and analyses, is for educational purposes only and does not constitute financial advice or recommendation. You should always conduct your own research before making any investment decisions and are solely responsible for your actions and investment decisions.
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