Definition
Liquidity pools are the backbone of decentralized exchanges (DEXs). Users deposit paired tokens (e.g., ETH/USDC) into a smart contract pool. Traders swap tokens against the pool rather than matching with another trader. Liquidity providers earn trading fees proportional to their pool share. The constant product formula (x × y = k) determines pricing. Impermanent loss is the primary risk for LPs.
functions Formula
x × y = k (Constant Product Formula)
lightbulb Example
A pool contains 100 ETH and $300K USDC (k = 30M). A trader buys 10 ETH: the pool must maintain k = 30M, so 90 ETH × new USDC = 30M. New USDC = $333,333. Trader pays $33,333 for 10 ETH (price impact: higher than spot).
verified_user Key Points
- Smart contract holding paired token reserves
- Constant product formula determines prices
- LPs earn trading fees but face impermanent loss
- Foundation of decentralized exchanges (DEXs)