Liquidity Pool (DEX)

A liquidity pool is a smart contract on a decentralized exchange (DEX) that holds a pair of tokens, enabling automated trading and liquidity provision without traditional order books.

What is Liquidity Pool (DEX)?

Liquidity pools are the backbone of decentralized exchanges (DEXs) like Uniswap, Sushiswap, and PancakeSwap, built primarily on Ethereum or compatible blockchains such as Binance Smart Chain or Solana. These pools consist of token pairs (e.g., ETH/USDC) deposited by liquidity providers (LPs) into smart contracts, allowing users to trade one token for another directly from the pool. The pool uses an automated market maker (AMM) model, typically based on a constant product formula (x * y = k), to determine token prices dynamically based on the ratio of the two assets. LPs earn trading fees (e.g., 0.3% per trade on Uniswap V3) proportional to their share of the pool, but face risks like impermanent loss when token prices diverge.

For example, Uniswap V3, with over $4 billion in total value locked (TVL) as of September 2025, allows LPs to deposit into an ETH/USDC pool at a 1:1 value ratio (e.g., 1 ETH at $3,000 paired with 3,000 USDC). A trader swapping 100 USDC for ETH reduces the pool’s USDC and increases its ETH, adjusting the price per the AMM formula. LPs supplying 1% of the pool’s liquidity earn 1% of the 0.3% fee per trade, potentially yielding 5-20% APY depending on trading volume, per DeFiLlama data. Sushiswap, with $500 million TVL, offers similar pools but incentivizes LPs with SUSHI tokens, boosting effective APY to 10-15% in high-volume pools. However, a 2023 exploit in a smaller DEX drained $10 million due to a smart contract bug, highlighting risks. LPs must also monitor impermanent loss, which can erode profits if ETH/USDC prices shift significantly (e.g., a 20% ETH price drop could cause a 5% loss relative to holding). Despite risks, liquidity pools enable 24/7 trading with $1.5 trillion in annual DEX volume in 2025.