In simple terms — A liquidity pool is a shared reserve managed by code. Users deposit a token pair into it; other users can swap those tokens under the AMM's rules.
In decentralized exchanges based on an automated market maker (AMM), the pool partly replaces a traditional order book. A person who deposits assets is called a liquidity provider (LP) and receives a share of the pool. This entry covers the DeFi meaning: in order-flow language, “liquidity pool” can instead be used informally for an area where orders or stops are clustered.
How an AMM pool works
A pair such as ETH/USDC contains reserves of both tokens. When someone buys ETH from the pool, they add USDC and reduce the ETH reserve. The AMM's mathematical rule changes the price as the ratio between the reserves changes. An order that is large relative to the pool usually creates more price impact and more slippage.
The provider deposits the assets required by the protocol and receives a representation of their share. Trading fees are allocated to the pool under the protocol's rules. On withdrawal, the LP does not necessarily receive the original quantities: they receive their share of the reserves at that moment. This is where the comparison with impermanent loss begins.
Yield and risk are not the same thing
Fees are observable revenue, but they do not guarantee a positive outcome. They must be compared with price changes, impermanent loss, temporary incentives, network costs, and possible losses from bugs or attacks on the smart contract. A small pool may also offer worse prices and be easier to drain or manipulate.
Before depositing, identify the contract, assets, fees, any price range, the withdrawal rules, and whoever retains administrative privileges. TVL measures the value deposited; it does not measure safety or the quality of the yield. Even a large pool can contain a fragile token or depend on a vulnerable protocol.
Sources
- Uniswap Docs — Pools — Explains reserves, LP shares, and the role of pools in an AMM.
- Uniswap — V2 whitepaper — Specifies the protocol's trading model, fees, and main economic effects.
- Uniswap — V3 whitepaper — Documents concentrated liquidity, price ranges, and inactivity outside the selected range.
Related entries
Impermanent loss · Liquidity mining · Yield farming · Rug pull