Liquidity Pool

What is a liquidity pool?

A liquidity pool is a smart contract that holds a pair or group of tokens, enabling decentralized trading without the need for traditional order books. Liquidity pools are fundamental to decentralized finance (DeFi), powering token swaps, lending markets, and yield-generating strategies. They emerged to address a key limitation of early decentralized exchanges (DEXs): the difficulty of matching buyers and sellers in real time.

In simpler terms, a liquidity pool holds two or more tokens and lets users trade between them automatically using a pricing formula. Anyone can deposit tokens into the pool and become a liquidity provider (LP), earning a share of trading fees in return. However, the value of an LP’s deposit can rise or fall due to price changes between the paired tokens.
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Why liquidity pools matter

Liquidity pools introduced several innovations that fueled the growth of DeFi, especially in niche token markets where centralized exchanges often lack volume or incentives:

• Continuous liquidity: Traders can swap tokens anytime without the need for a counterparty.
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• Permissionless access: Anyone can become a liquidity provider or trader, with no central authority or approval required.
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• Built-in incentives: LPs earn a share of trading fees, typically a percentage of each swap. Some protocols offer additional incentives, such as native tokens through liquidity mining programs. 
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How liquidity pools work

Liquidity pools function as automated, self-adjusting token reserves, where prices automatically adjust after each trade. When users deposit or swap tokens, a smart contract algorithm dynamically prices assets based on their relative supply. Trades then execute directly against this pooled liquidity without requiring a direct counterparty, since the liquidity itself is always available within the pool. 

While this core mechanism remains consistent, implementations vary significantly across protocols. Let’s consider the differences between Uniswap V2 and Curve V1:

Basic structure

Each pool holds a set of tokens and follows a specific pricing formula, depending on the platform:

• Uniswap V2: Pools consist of two tokens (like ETH and USDC) deposited in equal value. Each token must represent 50% of the total value, not quantity, at the time of deposit.
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• Curve V1: Stableswap pools often contain multiple stablecoins (such as USDC, DAI, and USDT), deposited in roughly equal value. These pools are designed specifically for assets with similar prices.
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Pricing mechanism

Most liquidity pools are governed by automated market makers (AMMs), protocols that use mathematical formulas to set prices instead of relying on central order books. These formulas adjust token prices based on the relative balances within the pool:

Uniswap V2: Uses the constant product formula (x × y = k), where x and y are the reserves of each token and k is a constant that remains unchanged after each trade. Prices adjust automatically based on supply and demand, meaning the more one token is bought, the more expensive it becomes relative to the other.

‍Example:

• Initial pool: 10 ETH and 20,000 USDC, k = 10 × 20,000 = 200,000
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• Initial price: 20,000 ÷ 10 = 2,000 USDC per ETH
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• Alice wants to buy 1 ETH:
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  • ETH reserve after trade: 9 ETH
  • Required USDC reserve: k ÷ 9 = 200,000 ÷ 9 = 22,222.22 USDC
  • Alice must deposit: 22,222.22 - 20,000 = 2,222.22 USDC
  • Effective price: 2,222.22 USDC per ETH, 11% higher than the initial amount; due to slippage (the difference between expected and actual trade prices)
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• Result: Alice receives 1 ETH, and the pool now holds 9 ETH and 22,222.22 USDC.

Curve V1: Uses a hybrid formula that blends constant product and constant sum (x + y = k) models with a tunable parameter (A) that controls how tightly the pool maintains a 1:1 price. When prices are near 1:1 the pool behaves more like a constant sum model for low-slippage trades, while farther from 1:1 it shifts toward a constant product model to maintain liquidity and balance. 

‍Example:

• Initial pool: 100,000 USDC, 100,000 DAI, 100,000 USDT
• Initial prices: All ≈ $1.00 (USDC ≈ DAI ≈ USDT)
• Alice wants to buy 10,000 DAI
  
  
  
  • Alice deposits: ≈10,050 USDC
  • Effective price: 1.005 USDC per DAI (0.5% slippage)
  • Pool after trade: 110,050 USDC, 90,000 DAI, 100,000 USDT

Note: Because AMMs do not rely on external price feeds, they depend on arbitrage traders (traders who profit from price differences) to keep the pool’s prices aligned with the broader market. When a token's pool price diverges, arbitrageurs buy the underpriced token and sell it elsewhere, rebalancing the pool. Since this process isn't instantaneous, users may face unfavorable prices or higher slippage until equilibrium is restored.
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Liquidity providers and LP tokens

Users create liquidity when they deposit tokens into a pool. The pool protocol then mints and distributes LP tokens to the user, which represent their share of the total pool. These tokens entitle them to a proportional share of trading fees and can be traded, staked in yield farming protocols, or used as collateral on lending platforms.
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• Uniswap V2: Anyone can become an LP by making equal value deposits of two tokens (e.g., ETH and USDC) in exchange for pool tokens. These LP tokens are shares of the total reserves and can be redeemed at any time. 
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• Curve V1: Users can become LPs by depositing one or more stable assets into a pool (e.g., DAI, USDC, USDT). In return, they receive LP tokens that represent their share of the pool and can be staked in the Curve DAO gauge system to earn CRV rewards and participate in governance.
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Trading dynamics

All trades are executed directly against the pool, and the pricing formula adjusts token values after each trade.
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• Uniswap V2: Suited for volatile token pairs. However, slippage can be significant on large trades due to its nonlinear pricing curve.
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• Curve V1: Optimized for stablecoins and other pegged assets. It offers low slippage even at high volumes by keeping prices closer to a 1:1 ratio.
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Examples

• Alice, as an LP: Alice deposits DAI and USDC into a Curve v1 stablecoin pool and in return receives LP tokens representing her share. These tokens entitle her to a portion of the trading fees generated by other users. If Alice later withdraws her liquidity, she redeems her LP tokens for a proportional share of the pool’s assets, potentially adjusted by price movements during her deposit period.
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• Bob, as a trader: Bob wants to exchange USDC for DAI. He uses the same pool and the AMM updates the exchange rate based on token balances, reducing USDC and increasing DAI in the pool. Alice earns a fee from his trade, even though they never interact directly.
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Assessing liquidity pools

Users often evaluate pools using metrics like total value locked (TVL), trading volume, and yield measurements. A high TVL signals deep liquidity, while high volume indicates active use. Annual percentage rate (APR) shows the simple yearly return from trading fees, while annual percentage yield (APY) accounts for compounding effects when fees are automatically reinvested. Together, these metrics help liquidity providers assess the potential earnings and the relative risk of different pools.
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Liquidity pool designs

Liquidity pool architectures have evolved to support a range of use cases. Below are some common models:
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Who uses liquidity pools?

Liquidity pools are foundational to many DeFi applications and DEXs. Common participants beyond LPs include:

• Traders: Use DEXs to swap tokens instantly at algorithmically set prices. Example: A trader swaps DAI for WBTC on Uniswap, bypassing a centralized exchange.
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• Protocols and decentralized autonomous organizations (DAOs): Use pools for lending, treasury operations, or cross-chain interoperability. Examples: Aave supplies assets to borrowers through pooled liquidity. Stargate maintains stablecoin pools across various chains, including Ethereum, Polygon, and Arbitrum, to support cross-chain swaps. DAOs such as Olympus deploy treasury-owned liquidity to sustain protocol operations and earn yield.
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Risks and trade-offs 

While liquidity pools unlock permissionless and efficient trading, they come with significant risks:
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• Impermanent loss: LPs may lose value when token prices diverge from their original ratio. In September 2022, ETH rose above $2,000 before falling to around $1,300. As ETH's price dropped, arbitrageurs bought ETH from ETH/USDC pools, leaving the pools with less ETH and more USDC. LPs who withdrew during this time received more USDC and less ETH, missing out on potential gains if ETH recovered. This loss is “impermanent” only while funds remain in the pool. Once withdrawn, the reduced value is locked in and becomes permanent.
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• Smart contract vulnerabilities: Bugs or flaws in the code can result in loss of funds. The Poly Network exploit in August 2021 led to $600M in losses. Wormhole lost $320M in a similar incident in 2022. These attacks typically target bridges, wrappers, or poorly audited DeFi protocols.
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• Economic exploits: Attackers may use flash loans or price manipulation to drain funds. Harvest Finance lost $34M in 2020 after flash loans were used to manipulate Curve pool prices.
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• Maximal Extractable Value (MEV): Validators or bots can reorder transactions to profit at users’ expense. This includes tactics like front-running or sandwich attacks (placing one trade before and one after a user’s transaction to profit from price changes). Impact: In 2021, it is estimated that $500M in MEV was extracted from DEX users, with Uniswap pools frequently targeted.