How do Defi liquidity pools work?

What Are Liquidity Pools?

Liquidity pools are collections of funds locked in smart contracts on a blockchain where users, known as liquidity providers (LPs), deposit pairs of tokens (for example, ETH and USDC). 

These pools allow decentralised exchanges (DEXs) like Uniswap or PancakeSwap to enable users to trade directly from the pool, without needing to find a matching buyer or seller at the moment of trade.

In simple terms, think of liquidity pools as a communal pot of tokens that anyone can trade against. 

LPs supply this pot and earn fees in return, while traders swap tokens instantly from this available liquidity.

Liquidity providers are everyday crypto users who add equal values of two tokens into a liquidity pool. 

By doing this, they create a market that others can trade against. In exchange, LPs earn a share of the transaction fees generated from trades within that pool. 

You can think of LPs as contributors who fill the "water bucket" (the liquidity pool) to ensure there’s enough water (tokens) for people to scoop out when they want to trade.

Comparing Defi Liquidity Pools with Order Books in Centralised Exchanges

In centralised exchanges like Binance or Coinbase, order books list all buy and sell orders awaiting matching. Trades execute only when prices match, so if no buyer matches a seller's price, the trade waits.

Liquidity depends on many buyers and sellers being active. 

In contrast, liquidity pools ensure constant liquidity since trades directly affect the balance in the pool following a formula, enabling instant swaps without waiting for counterparties.

What Are AMMs (Automated Market Makers)?

AMMs are algorithms powering liquidity pools that automatically set token prices based on the relative amounts of each token in the pool. 

The most common AMM formula is called the constant product formula, expressed as x×y=kx \times y = kx×y=k, where:

• xxx = amount of Token A in the pool,
• yyy = amount of Token B in the pool,
• kkk = a constant product that must remain unchanged.

When someone trades Token A for Token B, the quantities of tokens change, and the AMM adjusts prices accordingly to keep the product kkk constant. 

This mechanism enables price discovery without an order book and keeps liquidity available at all times, though large trades can shift prices significantly, causing slippage.

How Liquidity Pools Work in Defi Trading

Liquidity pools are the core mechanism behind decentralised trading on DEXs, enabling smooth swaps without the need for traditional buyers or sellers to be matched. 

Here's a simple breakdown:

Token Pairs in Liquidity Pools

A liquidity pool usually holds two types of tokens paired together, such as ETH/USDT or BNB/BUSD. 

These pairs are locked into a smart contract in roughly equal value. 

For example, if you deposit 1 ETH worth $1,000, you would also deposit $1,000 worth of USDT to balance the pool. 

These token pairs allow traders to swap between the two assets directly from the pool.

Role of Liquidity Providers (LPs)

Liquidity providers are people like you and me who add tokens to these pools. 

By doing so, LPs make trading possible on DEXs by ensuring there is always sufficient liquidity or "water in the bucket." 

In return for their contribution, LPs earn a share of the trading fees proportional to how much they have deposited. 

Think of LPs as contributors to a shared reservoir of tokens that others can trade against while earning a fee-based reward.

How Token Swaps Are Executed Using Pool Reserves

Swaps happen by interacting directly with the reserves of tokens in the pool. 

The automated market maker (AMM) smart contract adjusts the price dynamically depending on the quantities of the two tokens in the pool.

When a trader swaps Token A for Token B, they add to the reserve of Token A and remove some of Token B, causing the ratio to change and thus the price to shift.

A Simple Analogy: The See-Saw Balance

Imagine a see-saw with two kids sitting on either side, representing the two tokens in the pool. When one kid (token) moves down (is bought more), the other side moves up (becomes rarer and more expensive). 

The see-saw always wants to balance, just like the AMM formula x×y=kx \times y = kx×y=k keeps the product of reserves constant. The amounts shift, and prices adjust to keep the balance.

Or think of it like a water tank with two connected compartments pouring water (tokens) from one side to the other, which changes the levels, and the tank’s design ensures the total amount remains constant. But the ratio between compartments shifts, affecting how easy or costly it is to take water from one side.

This automatic balancing act is what enables instant trades without waiting for a buyer or seller on the other end, but it also means large trades in smaller pools can cause bigger price changes (slippage) because they unbalance the “see-saw” significantly.

How Liquidity and Price Slippage Affects Token Prices

Knowing how liquidity influences token prices can help you make better DeFi trading decisions, especially when dealing with less popular or newer tokens.

Here’s what you need to know:

Price slippage happens when your trade is executed at a different price than you expected. This usually occurs in pools with low liquidity; imagine a small bucket of water where scooping out even a little causes the water level to drop noticeably.

In crypto, if you try to buy or sell tokens in a shallow pool, your trade itself pushes the price up or down, costing you extra for big orders.

• Low liquidity = higher slippage: Big trades have a much bigger impact when there aren’t many tokens in the pool, leading to worse prices for the trader.
• High liquidity = lower slippage: Pools with lots of tokens absorb big trades more easily, so prices stay more stable.

How Large Trades Move Prices

When someone makes a significant trade like buying $10,000 worth of tokens, the impact depends heavily on the pool size:

• In a small liquidity pool: That $10,000 buy can shift the price a lot. The fewer tokens in the pool, the steeper the price climbs for each extra token you buy.
• In a large, deep pool: The same $10,000 trade barely shifts the price because the pool easily absorbs the order.

Trading Example: The $10,000 Trade

• Small pool example: If a token’s liquidity pool only has $50,000 in it, a $10,000 buy is 20% of the pool! This could move the price several percent or more, costing you more per token as you buy.
• Large pool example: With $5,000,000 in liquidity, buying $10,000 worth of tokens barely moves the price.

That’s why trading $10,000 of a not-so-popular token can send the price climbing high, but doing the same with USDT (a stablecoin with huge pools) barely makes a ripple.

Key Takeaways for You and Your Trades

• Avoid trading large amounts in low-liquidity pools. You’ll get worse prices due to slippage.
• For the best or better prices and lower slippage, look for tokens with deep pools.
• Always check the amount of liquidity in a pool before trading, especially if you’re trading larger sums.

Impermanent Loss and Risks for Liquidity Providers (LPs)

What is Impermanent Loss?

Impermanent loss is a type of temporary loss that happens when the value of the tokens you’ve deposited into a liquidity pool changes compared to when you first put them in. 

Simply put, if the price of one token in the pool goes up or down significantly relative to the other, the total value of your share in the pool can be less than if you had just held onto the tokens separately in your wallet. 

It’s called impermanent because the loss can disappear if prices return to their original levels, but if you withdraw your funds when prices have changed, the loss becomes permanent.

When Does Impermanent Loss Happen and Why?

Impermanent loss occurs because of the way automated market makers (AMMs) maintain the balance of token reserves in the pool. 

When prices of tokens diverge, arbitrage traders adjust the pool’s token amounts to reflect the new market prices, which can cause your underlying token amounts to shift. 

Despite the overall pool value staying relatively constant, the change in the token ratio means that your withdrawal might be worth less than simply holding the tokens outside the pool.

For example, if you deposited equal values of ETH and USDT, and the price of ETH rises sharply, the AMM will have you holding less ETH (the more expensive token) and more USDT (the cheaper token) to keep the product of amounts constant. 

So, while the total value may still grow, it usually does so less than if you had held the tokens independently.

Risk vs Reward: Trading Fees vs Potential Losses in Defi

Liquidity providers earn a share of trading fees paid by traders swapping tokens in the pool. These fees can sometimes make up for or even exceed impermanent loss, especially in pools with high trading volumes.

Additionally, some projects offer extra incentives such as yield farming rewards to offset the risk.

However, impermanent loss can still outweigh fees when token prices move sharply or remain volatile. 

LPs need to weigh this risk carefully against potential rewards, and it’s not always a guaranteed profit scenario.

Trading Example: ETH Price Rises by 20%, LP Experiences Loss

• Let’s say you provided liquidity with 1 ETH and an equivalent amount of USDT when ETH was priced at $1,000. 
• Your total deposit value is $2,000 (1 ETH + 1,000 USDT). Now, if ETH’s price rises 20% to $1,200, arbitrage trades will rebalance the pool so that your LP tokens now represent fewer ETH and more USDT.
• When you withdraw, despite ETH being more valuable, you might end up with, for example, 0.91 ETH and 1,090 USDT. 
• The total value of your withdrawal might be around $2,178, which is less than the $2,200 you would have had if you simply held 1 ETH and 1,000 USDT separately. This difference, roughly $22 in this example, is an impermanent loss, a penalty for the price divergence despite the price rising.
• This loss is impermanent since if ETH’s price returns to $1,000, your LP token value would also return to the original or close to it. But if you pull out while prices are different, the loss is realised.

How Liquidity Pools Are Important To Defi Crypto Traders and the Defi Market

Liquidity pools are fundamental to decentralised crypto trading, enabling smooth and efficient markets on DEXs without the need for traditional intermediaries. 

Here’s why they are so important:

1. Price Discovery on DEXs

On decentralised exchanges, liquidity pools power price discovery through automated market makers (AMMs). Each trade changes the balance of tokens in the pool, which automatically adjusts prices based on supply and demand. This continuous price adjustment helps reflect the current market value of tokens without relying on an order book or centralised price feeds. In short, liquidity pools create a transparent, real-time market price determined by the flow of trading activity.

2. Arbitrage Opportunities

Because token prices in liquidity pools can differ from prices on centralised exchanges or other DEXs, arbitrage traders step in to buy low on one platform and sell high on another. Their trades help rebalance the pools and align prices across markets. This arbitrage activity ensures price consistency and efficiency across the broader crypto ecosystem, benefiting all traders by maintaining fair market prices.

3. Impact of LPs on Entering and Exiting Positions

Liquidity providers (LPs) supply the token pairs that form these pools, and their participation directly affects how easily traders can enter or exit positions. Larger and deeper liquidity pools mean trades can be executed with minimal price impact and less slippage, making for smoother trading experiences. Conversely, lower liquidity means trades cause greater price changes, making it harder to buy or sell tokens at expected prices.

How to Check a Token’s Liquidity Before Trading

There are easy-to-use tools that let you quickly assess a token’s market depth.

Essential Tools for Liquidity Checks

• DEX Screener: This platform tracks tokens across many DEXs, showing real-time data like liquidity, trading volume, and recent price movements.
• Uniswap and PancakeSwap: These popular DEXs provide direct info about a token’s pool size, recent trades, and analytics within their own ecosystems.
• DeFiLlama: This site aggregates total value locked (TVL) and volume metrics from DEXs and liquidity pools, offering a macro view of liquidity across chains and protocols.

What Should You Look For?

Use these metrics:

• Total Value Locked (TVL)
  • Represents the dollar value of all tokens in a specific pool or protocol.
  • A higher TVL means deeper liquidity, giving your trades more “room” and stability.
  • Example: A pool with $10 million TVL is usually much safer to trade than one with only $50,000.
• 24h Trading Volume
  • Shows how much of the token has been traded in the last day.
  • High trading volume signals active interest and lots of buyers/sellers, reducing the chance of getting stuck in a position.
• Pool Size vs. Trade Size
  • Compare the size of your intended trade to the pool’s total liquidity.
  • As a rule of thumb, trading more than 2-3% of the pool size will result in significant price impact and higher slippage.
  • If a pool has $100,000 in liquidity, keep single trades well below $2,000–$3,000 for best results.

Quick Steps to Check Liquidity

1. Find the Pool: Paste the token address into DEX Screener, Uniswap, PancakeSwap, or DeFiLlama.
2. Note TVL and Volume: Look for the TVL and 24h trading volume numbers. Look for pools with high figures relative to your trade size.
3. Calculate Trade Impact: Use available tools’ built-in “trade preview” or “swap” calculators; they’ll show expected slippage before you confirm.

Trading Example

Suppose you want to trade a token on PancakeSwap. You check the pool and see:

• TVL: $20,000
• 24h volume: $3,000

If you want to swap $5,000, that’s 25% of the entire pool, expect huge slippage and a poor fill. But if you’re only swapping $100, the pool can easily handle it.

Understanding Liquidity Pools: Key Takeaways for DeFi Traders

• Liquidity pools are essential: They enable instant, trustless trades on DEXs by letting anyone swap tokens directly from a pool rather than relying on traditional order books or counterparty matching.
• Check liquidity before trading: Always check the pool’s total value locked (TVL) and 24-hour trading volume. Avoid trading large amounts in small pools to minimise slippage and volatility.
• Understand price impact: Big trades in shallow pools can move prices a lot, leading to worse rates (slippage) for the trader. For smoother trading and better pricing, stick to tokens with deep liquidity.
• Impermanent loss affects LPs: Providing liquidity has rewards, like earning trading fees, but also exposes you to the risk of impermanent loss when token prices shift.
• Arbitrage balances the market: Arbitrage activity helps keep prices aligned between DEXs and centralised exchanges, but illiquid pools can still have unstable prices.
• Token reliability varies: Tokens with poor liquidity are harder and riskier to trade. Reliable trading requires robust, active pools with plenty of participants.

Your DeFi Trade Liquidity Checklist

Before trading or providing liquidity on a decentralised exchange, use this checklist to protect your funds and get better trading results:

For All Trades

□ Check token liquidity: Use DEX Screener, Uniswap, PancakeSwap, or DeFiLlama to check the pool’s total value locked (TVL) and 24h trading volume.

□ Compare trade size to pool size: Make sure your trade is less than 2–3% of the pool’s total liquidity to minimise slippage.

□ Preview your trade: Use the DEX’s built-in swap calculator to view estimated slippage and price impact before confirming.

□ Look for deep pools: Go for tokens with high TVL and strong trading volume; avoid small, inactive pools.

□ Check recent price movements: Scan recent trades in the pool for volatility, which could signal higher risk or unstable pricing.

If Providing Liquidity (as an LP)

□ Understand impermanent loss: Review potential scenarios for impermanent loss if token prices diverge sharply.

□ Evaluate trading fees and rewards: Assess if anticipated fee earnings (and possible LP incentives) outweigh the risks of price changes.

□ Confirm pool security: Check for audited smart contracts and see if the pool’s liquidity is locked (reducing rug-pull risk).

□ Diversify pools: Don’t put all tokens in one pool; diversify to spread out risk across multiple assets or platforms.

General Best Practices

□ Start with small amounts: Especially for new tokens or pools. Test with a small trade to gauge price impact and slippage.

□ Monitor regularly: Pool dynamics change. Watch TVL, volume, and rewards over time, especially for smaller tokens.

□ Have an exit plan: Make sure there’s enough liquidity to exit your position smoothly when you’re ready to trade out.

□ Stay informed: Follow trusted analytics platforms and community updates for any significant changes to pools or smart contracts.

FAQs: Liquidity Pools and Their Impact on Token Prices

1. What is a liquidity pool in crypto?
A liquidity pool is a collection of cryptocurrency tokens locked in a smart contract on a blockchain. These pools are created by users called liquidity providers (LPs) who deposit pairs of tokens (like ETH/USDC) to enable decentralised exchanges (DEXs) to facilitate instant trades without needing a buyer or seller on the other side. Automated market maker (AMM) algorithms automatically determine token prices based on their ratio in the pool to keep trades smooth and liquid.

2. Do liquidity pools make money?
Yes. Liquidity providers earn money mainly through a share of trading fees generated each time someone swaps tokens in the pool. Additionally, some pools offer extra incentives such as governance tokens or yield farming rewards. However, returns depend on trading volume and market conditions, and profits can be offset by risks like impermanent loss.

3. Can you lose crypto in liquidity pools?
Yes, you can lose value due to impermanent loss, which occurs when the price of tokens in the pool diverges significantly from their initial levels, causing your share of the pool to be worth less than simply holding the tokens independently. You also face risks from smart contract bugs or exploitation, market volatility, and risks of liquidity being withdrawn suddenly by others (rug pulls).

4. What happens when a liquidity pool dries up?
If a liquidity pool "dries up," it means there’s very little liquidity left because LPs have withdrawn their tokens. This leads to higher slippage and price volatility, making trades expensive or even impossible. Traders might struggle to enter or exit positions smoothly, and token prices can swing sharply as even small trades heavily impact the pool balance.

5. Can you withdraw from a liquidity pool?
Yes. Liquidity providers can withdraw their tokens anytime by redeeming their LP tokens, which represent their share of the pool. When you withdraw, you receive your original tokens (plus any earned fees, minus impermanent loss if applicable). Upon withdrawal, the smart contract burns the LP tokens, and the underlying assets are returned to your wallet.

6. How to make money in crypto liquidity pools?
You can earn money by providing liquidity to pools and collecting a share of the trading fees paid by users swapping tokens. Additionally, some pools reward LPs with extra tokens (yield farming). However, successful LPs manage risks like impermanent loss and choose pools with high trading volumes to maximize fee earnings.

7. How much does it cost to make a liquidity pool?
The cost to create a liquidity pool depends on the blockchain network fees (gas fees) for deploying smart contracts and the initial token amounts you deposit. Usually, liquidity pools require depositing equal dollar values of two tokens. The cost is token-specific and can vary widely depending on network congestion and the tokens involved.

8. How do I add money to my liquidity pool?
To add liquidity, connect your crypto wallet to a DeFi platform (like Uniswap or PancakeSwap), navigate to the liquidity section, select the token pair you want to provide (e.g., ETH/USDT), and deposit equal dollar amounts of both tokens. You’ll receive LP tokens representing your share. This process locks your tokens in the smart contract and makes them available for traders to swap.

Disclaimer: This article was written to provide guidance and understanding. It is not an exhaustive article and should not be taken as financial advice. Obiex will not be held liable for your investment decisions.