How Do Liquidity Pools Work?
Liquidity pools are a fundamental component of decentralized finance (DeFi) that facilitate trading on decentralized exchanges (DEXs). They consist of a collection of funds locked in a smart contract, which provides liquidity for trading pairs without requiring a traditional order book.
Investors contribute to liquidity pools by depositing an equal value of two different cryptocurrencies, for example, ETH and USDT, into the pool. In return, they receive liquidity provider (LP) tokens, which represent their share in the pool. These LP tokens can be staked or traded to earn rewards or to withdraw funds at any time.
When users trade one cryptocurrency for another within the pool, an automated market maker (AMM) algorithm determines the price based on the ratio of tokens available in the pool. The constant product formula, often expressed as x * y = k, ensures that the product of the quantities of the two tokens remains constant, adjusting their prices as trades happen.
Liquidity providers earn a share of the transaction fees generated from traders using the pool. However, they also face risks, such as impermanent loss, which occurs when the price ratio of the pooled tokens changes significantly compared to when they were deposited. Overall, liquidity pools enable efficient, decentralized trading while incentivizing users with rewards.