What is Liquidity pool?

How it works

A pool is initialized by depositing equal dollar values of two tokens — say $10,000 USDC and 3 ETH at $3,333 each ($9,999). The depositor receives "LP tokens" representing their share of the pool. Other users can deposit later and receive proportionally more LP tokens.

When traders swap against the pool, the AMM formula keeps reserves balanced and a small fee (0.30% on Uniswap V2, 0.05–1.0% on V3) accumulates as additional reserves. LPs withdraw at any time by burning their LP tokens for a slice of whatever the pool currently holds.

Example

You provide liquidity to a USDC/ETH pool with $1,000 each ($2,000 total). Six months later:

• The pool has earned 0.30% × $50M of swap volume × your share = some fees
• ETH price has gone from $3,333 to $5,000
• Because of the constant-product formula, the pool now holds proportionally more USDC and less ETH (it auto-rebalanced as ETH became more expensive)

You withdraw and receive (say) $1,200 USDC + 0.18 ETH = $1,200 + $900 = $2,100. But if you'd just held the original $1,000 USDC + 0.30 ETH you'd have $1,000 + $1,500 = $2,500.

The $400 difference is impermanent loss. Whether the trading fees you earned beat that gap determines whether LPing was profitable. For volatile pairs, often the fees don't cover IL.

Why it matters

Pool concepts to understand before LPing:

• Pool depth = your slippage. The bigger the pool, the smaller individual trades affect price (and the smaller your share of each trade's fee).
• Pair correlation. USDC/USDT pools have minimal IL because both stay near $1. ETH/USDC pools have meaningful IL because ETH moves freely.
• Concentrated liquidity (Uniswap V3 model). Providing within a tight band earns more fees per dollar but accelerates IL when price exits the band.
• TVL as quality signal. A pool with $50M+ TVL tends to be safer and more efficient than one with $200k. Tiny pools attract bots that game them.

For most retail users: passively buying tokens (not LPing) is simpler and avoids IL entirely. LPing is for people who understand the math, have a thesis on volatility staying low for the pair, and accept that "5% APY" on the LP can still trail "0% APY" on simple holding.