Finder makes money from featured partners, but editorial opinions are our own. Advertiser disclosure

How Liquidity Pools Work

A beginner-friendly look at how crypto liquidity pools function, generate returns and what could go wrong.

Shane Neagle's headshot
Holly Jennings's headshot

By

Shane Neagle

&

Holly Jennings

Edited by

Holly Jennings

Reviewed by

Richard Laycock

Updated

Fact checked

  • Commitment to our readers

    18 years

    Helping you save money

    Reviewed

    by experts

    Cited by

    major publications

    Finder maintains full editorial independence to ensure for our readers a fair assessment of the products, brands, and services we write about. That independence helps us maintain our reader's trust, which is what keeps you coming back to our site. We uphold a rigorous editorial process that ensures what we write and publish is fair, accurate, and trustworthy — and not influenced by how we make money.

    We're committed to empowering our readers to make sound and often unfamiliar financial decisions.

Liquidity pools are one of the building blocks of decentralized finance (DeFi). They let users trade crypto without relying on a traditional order book or a centralized intermediary.

A liquidity pool is a collection of crypto assets locked in a smart contract. Users called liquidity providers (LPs) deposit assets into these pools, while other users trade against them. In return, liquidity providers can earn a share of trading fees and, in some cases, additional rewards.

Understand liquidity pools in 30 seconds

FeatureHow liquidity pools work
Liquidity poolA smart contract holds crypto that users can trade against
Liquidity providers (LPs)Users deposit assets into a pool to make trading possible
Token pairsMost pools contain two tokens, such as ETH and USDC
TradingTraders swap one token for another directly against the pool rather than with another trader
PricingAn automated market maker (AMM) uses a mathematical formula to determine prices based on the pool’s token balances
LP rewardsLPs can earn a share of trading fees and, in some cases, additional token incentives
RebalancingTrades change the amount of each token in the pool, causing the pool’s price to adjust
Main riskImpermanent loss can occur when the relative prices of the pooled tokens change

How do liquidity pools work?

Liquidity pools use smart contracts to hold crypto that traders can swap without needing to find a specific buyer or seller. The process typically works like this:

  1. Liquidity providers deposit assets. Liquidity providers (LPs) deposit crypto into a liquidity pool through a decentralized exchange (DEX). Most pools require LPs to deposit two assets in a set ratio, such as ETH and USDC.
  2. The pool holds the token pair. The deposited assets are held by a smart contract rather than by the LP or DEX itself. The pool’s balances determine how much liquidity is available for traders.
  3. Traders swap against the pool. Instead of matching traders with each other through an order book, a DEX routes trades through the liquidity pool. A trader might exchange USDC for ETH, for example. The USDC goes into the pool, while ETH comes out. The trade changes the pool’s token balances and, consequently, the price of the assets.
  4. An automated market maker (AMM) determines the price. Most liquidity pools use an automated market maker to determine the exchange rate between the tokens. Rather than relying on a buyer and seller to agree on a price, the AMM uses a mathematical formula based on the pool’s available assets.
  5. Trading fees go to liquidity providers. DEXs typically charge a fee on each swap. A portion of these fees is distributed to the liquidity providers who supplied the assets used for trading.
  6. LPs withdraw their share. When an LP wants to exit, they can remove their liquidity from the pool. They receive the assets represented by their share of the pool at that time, minus any applicable fees.

What is a liquidity provider?

A liquidity provider (LP) is a person or entity that deposits crypto assets into a liquidity pool to make them available for trading. In return, LPs can earn a portion of the fees generated by trades through the pool and may receive additional rewards.

  • Who can become a liquidity provider? Anyone with a compatible crypto wallet and the assets required by a pool can generally become an LP.
  • What assets do you need? Most liquidity pools contain two tokens, and to provide liquidity, you generally need both assets. However, some newer protocols use pools that support multiple assets or allow single-sided liquidity.
  • Why do you need two tokens? A two-token pool needs both assets so traders can swap between them. When someone buys ETH from an ETH/USDC pool, for example, their USDC goes into the pool while ETH leaves it.
  • What happens to your crypto after you deposit it? Your assets are transferred to the pool’s smart contract. You no longer control those specific tokens while they are being used as liquidity. Instead, you hold a claim on your share of the pool.
  • What are LP tokens? Some protocols issue LP tokens when you deposit liquidity that represent your share of the pool. Some more modern protocols, particularly those using concentrated liquidity, represent liquidity positions as NFTs or track them through another mechanism.

How do liquidity providers make money?

Liquidity providers can earn money in several ways, depending on the protocol and the pool. The most straightforward source is trading fees, but some DeFi protocols offer additional incentives to attract liquidity.

Source of returnsHow it works
Trading feesTraders pay a fee when they swap tokens. A portion of those fees is distributed to liquidity providers.
Liquidity miningA protocol rewards users for supplying liquidity, often by distributing its own tokens.
Yield farmingLPs move their liquidity between pools or protocols to pursue higher yields, sometimes using additional DeFi strategies to generate returns.
Token incentivesA protocol may distribute bonus tokens to LPs on top of trading fees to encourage liquidity in a particular pool.

Why liquidity pool returns can be difficult to predict

A pool’s advertised APY or APR is not a guaranteed return. The amount an LP actually earns depends on what happens in the pool after they deposit.

  • Trading volume matters. More trading generally means more fees generated by the pool. A pool with high trading volume can therefore generate more income from fees than a similarly sized pool with little activity.
  • Pool size matters. Your share of the fees depends partly on how much liquidity you provide relative to the rest of the pool. If other LPs add substantial liquidity, your share of future fees may decrease even if trading volume stays the same.
  • Token prices matter. The value of the assets in your position changes as their market prices move. If one token rises or falls significantly relative to the other, the pool’s composition can change and your returns can differ substantially from the fees you earned.
  • Incentive tokens can change in value. An attractive yield may include rewards paid in a protocol’s own token. If that token falls sharply in price, the value of those rewards can be much lower than the advertised APY suggests.

This means a pool offering a higher APY isn’t necessarily more profitable than one offering a lower APY. The headline yield is only one part of an LP’s potential return. Fees, token prices, incentives and impermanent loss all affect the outcome.

What is impermanent loss?

Impermanent loss (IL) is the potential loss in value that occurs when the price of one token in a liquidity pool changes relative to the other. It happens because the pool’s AMM automatically adjusts token ratios as traders buy and sell them.

For example, suppose you deposit $500 of ETH and $500 of USDC into a pool. If the price of ETH rises significantly while you’re providing liquidity, arbitrage traders will buy ETH from the pool until its price more closely matches the broader market. You may end up with less ETH and more USDC than you originally deposited.

If you had simply held the original ETH and USDC instead, your holdings could be worth more than your liquidity position. That difference is the impermanent loss.

Which pools have less impermanent loss?

The risk generally increases when the prices of the two assets diverge significantly. Pools containing assets that tend to maintain a similar value, such as certain stablecoin pairs, generally have less exposure to impermanent loss than pools containing highly volatile assets.

Other risks of liquidity pools

Impermanent loss isn’t the only risk to consider. Liquidity pools rely on smart contracts and volatile crypto markets, and both liquidity providers and traders can lose money.

  • Smart contract risk. Liquidity pools are controlled by smart contracts. A bug or vulnerability in the contract could allow an attacker to drain funds or otherwise disrupt the protocol.
  • Rug pulls and malicious pools. Permissionless DEXs can allow almost anyone to create a liquidity pool, including pools involving fraudulent or malicious tokens. Developers can sometimes withdraw liquidity, manipulate a token’s price or use other mechanisms to steal investors’ funds.
  • Slippage and low liquidity. Slippage is the difference between the price you expect to receive for a trade and the price you actually get. A large trade against a small pool can significantly change the pool’s token balance and result in a less favorable execution price.
  • Market risk. If the tokens in a pool fall in value, the value of your position can fall as well. LPs can also face additional exposure because the pool automatically changes its mix of assets as traders buy and sell, which can leave you holding a different proportion of the tokens than you originally deposited.
  • MEV and transaction risks. On some blockchains, traders and other participants can observe pending transactions and attempt to profit from them through maximal extractable value (MEV) strategies. These can include transaction ordering and arbitrage that affects the price a trader receives.

Types of liquidity pools

Not all liquidity pools work the same way. The pool’s design affects how prices are calculated, how liquidity is supplied and the risks and potential returns for liquidity providers.

TypeHow it works
Constant-product poolsUse the traditional AMM model, such as x × y = k, to maintain liquidity between two tokens.
Concentrated liquidity poolsLPs choose a specific price range in which their liquidity is available, potentially increasing capital efficiency but requiring more active management.
Stablecoin poolsPair assets designed to maintain similar values, such as different stablecoins, to facilitate swaps with relatively low price impact.
Multi-asset poolsHold more than two tokens in a single pool, allowing traders to swap between multiple assets.
Single-sided poolsAllow users to provide liquidity with one asset rather than requiring a deposit of two tokens, although the underlying mechanics vary by protocol.

The distinctions aren’t always mutually exclusive. For example, a stablecoin pool can also use a concentrated-liquidity model. The important difference lies in how the pool manages liquidity and determines prices, not which tokens it contains.

How to choose a liquidity pool

There isn’t a single best liquidity pool for every investor. A pool with a high advertised APY may carry substantially more risk than one offering a lower return.

Before depositing your crypto, look beyond the headline yield and consider how the pool generates its returns and what could affect your position.

What to checkWhy it matters
Trading volumeHigher trading volume can generate more fee revenue for LPs, although volume can fluctuate significantly.
Total liquidityLarger pools can generally handle bigger trades with less price impact. Your share of the pool also affects how much of the trading fees you receive.
Token pairConsider how volatile the assets are and how their prices tend to move relative to each other. Large price differences can increase impermanent-loss exposure.
Fee tierHigher trading fees can increase potential LP revenue, but they may also discourage trading and reduce volume.
Historical fees and revenuePast fee generation can give you a better idea of how actively a pool has been used than its advertised APY alone. Past performance isn’t a guarantee of future returns.
Impermanent-loss exposureConsider how much the tokens’ prices could diverge and how that could affect the value of your position.
Token incentivesAdditional rewards can increase the advertised yield, but check what the rewards are worth and whether their value is likely to remain stable.
Smart-contract securityLook for established protocols and published security audits, while remembering that an audit doesn’t eliminate smart-contract risk.
Protocol reputationConsider the protocol’s history, transparency, development team and track record before depositing funds.
Network and gas costsTransaction fees can reduce your returns, particularly when providing or withdrawing smaller amounts of liquidity.
Liquidity rangeFor concentrated-liquidity pools, check the selected price range. If the market moves outside your range, your liquidity may stop earning trading fees until the price returns.

How to provide liquidity

The exact process varies by decentralized exchange (DEX) and liquidity pool, but providing liquidity generally involves the following steps:

  1. Choose a DEX and liquidity pool. Research the DEX and pool you want to use. Consider the pool’s liquidity, trading volume, fee structure, supported assets, potential rewards and associated risks before depositing any funds.
  2. Connect a crypto wallet. You’ll need to hold the required tokens as well as enough of the network’s native cryptocurrency to pay transaction fees, such as ETH for transactions on Ethereum.
  3. Choose a token pair. Select the pool you want to provide liquidity to. Traditional pools typically require two tokens, such as ETH and USDC, while some protocols support multi-asset or single-sided liquidity.
  4. Deposit the required assets. Enter the amount of liquidity you want to provide, then approve the transaction in your wallet. The assets will be transferred to the pool’s smart contract once the transaction is confirmed.
  5. Confirm the transaction. Once the transaction is confirmed on the blockchain, your assets are being used as liquidity in the pool.
  6. Receive your LP position. Depending on the protocol, you’ll receive LP tokens or another representation of your liquidity position.
  7. Monitor your position. Keep track of the pool’s trading activity, fees, rewards and token prices. Some pools, particularly those with concentrated liquidity, may also require you to adjust your position if prices move outside your selected range.
  8. Remove your liquidity. When you’re ready to exit, use the DEX’s interface to withdraw your liquidity. You’ll receive the assets represented by your position at that time, along with any applicable fees or rewards.

Hot tip

Blockchain transactions are generally irreversible. Check the wallet address, token amounts and transaction details before confirming a deposit or withdrawal. If you approve a malicious transaction or send assets to the wrong address, recovering the funds may not be possible.

Liquidity pools vs. staking

Liquidity pools and staking can both generate rewards from crypto you already hold, but they serve different purposes and involve different risks. Staking generally helps secure a proof-of-stake blockchain, while liquidity pools provide assets that traders can use to swap tokens.

Liquidity poolsStaking
What you provideUsually two tokensUsually one token
Primary purposeFacilitate trading on a DEXHelp secure and validate a proof-of-stake blockchain
How you earnTrading fees and potentially additional rewardsStaking rewards
Impermanent lossPossibleNot a typical staking risk
Price riskYesYes
ComplexityGenerally higherGenerally lower

The two strategies aren’t mutually exclusive. You can potentially stake some crypto while using other assets to provide liquidity. The better option depends on your goals, the assets you hold and how much risk and complexity you’re willing to accept.

Bottom line

Liquidity pools let users earn fees by supplying crypto to decentralized exchanges, but the returns come with risks.

Before providing liquidity, consider the pool’s fees, trading volume, token volatility, impermanent-loss exposure and smart-contract security. A high APY doesn’t guarantee a better return.

Compare exchanges where you can buy and sell cryptocurrencies

5 of 17 results
Finder Score Fiat currencies Cryptocurrencies Deposit methods Disclaimer
8.6Great
50
1086
Cryptocurrency, PayPal, P2P
Not available for US citizens
Go to site

Capital at risk

More info
Compare product selection
8Great
73
281
Bank transfer, Credit card, Cryptocurrency, Debit card, P2P
Disclaimer: Highly volatile investment product. Your capital is at risk. Not available for US citizens
Go to site

Capital at risk

More info
Compare product selection
8.4Great
141
753
Bank transfer, Credit card, Cryptocurrency, Debit card, Apple Pay, Google Pay
Not available for US citizens
Go to site

Capital at risk

More info
Compare product selection
OKX logo
9.4Excellent
OKX Cryptocurrency Exchange
9.4Excellent
1
181
Bank transfer (ACH), Debit card, Wire transfer, Apple Pay, Google Pay, Plaid
Go to site

Capital at risk

More info
Compare product selection
eToro logo
8.2Great
eToro USA LLC Cryptocurrency Trading
Finder Award
8.2Great
26
105
Bank transfer, Debit card, PayPal, Wire transfer
Crypto Trading is offered via eToro USA LLC (NMLS ID: 1769299). This entity is not a registered broker-dealer or FINRA member and your cryptocurrency holdings are not FDIC or SIPC insured. Investments are subject to market risk, including the possible loss of principal.
Important information
Cryptocurrency is offered by eToro USA LLC (“the MSB”) (NMLS: 1769299) and is not FDIC or SIPC insured. Investing involves risk, and content is provided for educational purposes only, does not imply a recommendation, and is not a guarantee of future performance. [website domain name] is not an affiliate and may be compensated if you access certain products or services offered by the MSB.
Go to site

Capital at risk

More info
Compare product selection
loading
Showing 5 of 17 results

Frequently asked questions

Disclaimer: This page is not financial advice or an endorsement of digital assets, providers or services. Digital assets are volatile and risky, and past performance is no guarantee of future results. Potential regulations or policies can affect their availability and services provided. Talk with a financial professional before making a decision. Finder or the author may own cryptocurrency discussed on this page.

Holly Jennings's headshot
Richard Laycock's headshot
To make sure you get accurate and helpful information, this guide has been edited by Holly Jennings and reviewed by Richard Laycock, a member of Finder's Editorial Review Board.
Shane Neagle's headshot
Written by

Contributor
Add to Preferred Sources

Shane's career started with the US Department of Defense where he performed research for 8 years. He then studied philosophy and became fascinated by the ways in which technology and finance can consolidate to impact the world's socio-economic order. To date, he has written hundreds of articles with various insights into digital assets, trading, investing, and the ways in which technology can be used to further optimize the stock trading and settlement processes. His work has been featured in Yahoo Finance, Nasdaq, Bitcoin Magazine, Investing.com, Tokenist, and others. See full bio

Holly Jennings's headshot
Co-written by

Deputy Crypto Editor

Holly Jennings is the deputy crypto editor and updates writer at Finder, working with writers across all niches to deliver quality content to readers. She’s edited hundreds of financial articles ranging from credit cards to investments. With empathy at heart, she especially enjoys content that breaks down complex financial situations into easy-to-understand information. Prior to her role at Finder, she collaborated with dozens of small businesses to maximize the reach and impact of their blog posts, website copy and other content. In her spare time, she is an award-winning author for Penguin Random House, writing about virtual reality worlds, magical girls and lasers that go pew-pew. See full bio

Holly's expertise
Holly has written 49 Finder guides across topics including:
  • Cryptocurrency
  • Digital assets
  • Investments
  • Personal Banking
More resources on Finder

Ask a question

Finder.com provides guides and information on a range of products and services. Because our content is not financial advice, we suggest talking with a professional before you make any decision.

By submitting your comment or question, you agree to our Privacy and Cookies Policy and finder.com Terms of Use.

Questions and responses on finder.com are not provided, paid for or otherwise endorsed by any bank or brand. These banks and brands are not responsible for ensuring that comments are answered or accurate.

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.

More guides on Finder

Go to site