Traditional venues use an order book, where buyers and sellers post prices and the exchange matches them. A pool replaces that with a formula. The contract holds reserves of each token, and the price it offers comes from the ratio between those reserves. Buy one side and the reserves shift, which nudges the price, and that is why a large trade against a small pool moves the quoted rate so sharply. Traders feel this as <a href="/glossary/slippage/">slippage</a>.
Depositors normally supply both sides in the ratio the pool requires and receive an LP token representing their claim on the reserves. Fees from every swap accrue to the pool, so that claim grows slowly as trading happens. Pool depth matters to everyone involved, since deeper reserves mean better prices for traders and less influence for any single order, which is why aggregate deposits get tracked as <a href="/glossary/total-value-locked/">total value locked</a>.
The risk is where beginners get hurt. Because a pool constantly rebalances toward whichever token is being bought, a provider ends up holding more of the asset that fell and less of the one that rose. That gap between the pool balance and simply having held the two tokens is <a href="/glossary/impermanent-loss/">impermanent loss</a>, and it becomes entirely permanent the moment you withdraw. Layered on top are smart contract bugs, tokens that turn out to be worthless, and pools created purely to trap deposits. Fee income is the payment for carrying all of that.
DeFi Basics and Risks
Key takeaways
- A pool prices trades from the ratio of its reserves, so your trade size relative to pool depth decides the rate you get.
- Providing liquidity is a position rather than a savings account, because your mix of tokens changes automatically as the market moves.
- Fees only compensate you if they outweigh divergence between the assets, contract risk and the chance a token becomes worthless.
Liquidity Pool — frequently asked questions
Where do the fees paid to liquidity providers come from?
From traders. Each swap pays a small cut that stays in the pool rather than going to a company, and it is divided among depositors in proportion to their share. More trading volume means more fees collected. It also means a quiet pool earns very little while still exposing you to every one of the risks of being in it.
Can I lose money in a pool even if both tokens go up?
Yes. If the two assets move by different amounts, the pool rebalances toward the weaker one, and you can end up with less value than if you had simply held both. Fees may or may not close that gap. And if the contract is exploited or one of the tokens collapses, the losses go well beyond it.
Related terms
Automated Market Maker (AMM)Impermanent LossDecentralised Exchange (DEX)Yield FarmingTotal Value Locked (TVL) All terms →New to crypto, or filling in the gaps? Work through the essentials in Learn, browse every term A–Z, or see live prices for the coins these concepts power.