What is a liquidity pool? How does it work?

Friend who’s just stepped into the world of DeFi! Have you often swapped tokens on Decentralized Exchanges (DEXs) like Uniswap or PancakeSwap, but always had a nagging question: “Weird, I just click a button and the trade goes through instantly, unlike on Binance where I need to place an order and wait for someone to match it. So… where did my money actually go? Who am I trading with?”

If this has been puzzling you, congratulations, you’ve hit on a key point! The hero behind the scenes is what we’re discussing today: the Liquidity Pool.

1. What on Earth is a Liquidity Pool? Think of it as a “Shared Swap Shop”

First, let’s consider how traditional exchanges (like Binance, Coinbase, Kraken) work: If you want to buy USDT with $100, you place a buy order. If someone wants to sell USDT for dollars, they place a sell order. The exchange acts like a matchmaker, pairing up buyers and sellers whose prices agree. This is the “order book model.”

But many DEXs don’t operate this way. They’re more like countless “self-service shared swap shops,” each dedicated to swapping only two specific tokens. For example, one shop might specialize in swapping ETH and USDT, while another handles BTC and ETH.

The “inventory cash” of this “self-service shared swap shop” is the Liquidity Pool.

• Who opens the shop/provides inventory? Anyone can! As long as you hold both tokens involved (e.g., ETH and USDT), you can deposit them together into the shop’s “shared vault” according to the current price ratio. People who provide these funds are called Liquidity Providers (LPs).
• What’s in the vault? It’s a large collection of paired tokens contributed by all the LPs. For instance, an ETH/USDT pool contains a lot of ETH and a lot of USDT.

2. How Does Trading with a Pool Work? (Here’s the important part!)

This is the key to answering your “where did my money go?” question! When you want to trade using a pool, say, swapping 1 ETH from your wallet for USDT:

1. You “Deposit” Funds into the Pool: You send your 1 ETH to the smart contract address of the ETH/USDT liquidity pool. (Think of a smart contract as the automated rules and ledger for this “swap shop”).
2. The Pool “Calculates” Your Payout: Based on the current ratio of ETH and USDT amounts in the pool (governed by a mathematical formula, often x*y=k, but you don’t need the details — just know it automatically determines the exchange rate based on the balance), the smart contract calculates how much USDT your 1 ETH can be exchanged for. Simply put: the more ETH is in the pool relative to USDT, the fewer USDT you’ll get for your ETH, and vice-versa.
3. The Pool “Dispenses” Funds to You: The smart contract automatically sends the calculated amount of USDT from the pool’s existing USDT inventory to your wallet address.

Got it? The whole process:

• The ETH you paid went into the shared pool, increasing the amount of ETH in it.
• The USDT you received came from the shared pool, decreasing the amount of USDT in it.
• Your counterparty wasn’t a specific person, but the “Liquidity Pool” itself! You directly swapped tokens with this “pot of money.” This is why swaps on DEXs are usually instantaneous — as long as the pool has enough tokens, the trade executes immediately without needing to wait for a matching order.

3. So… Who Actually Got the Money? What About Trading Fees?

Let’s reiterate: The coins you paid went into the pool; the coins you received came from the pool. The money didn’t directly flow to some “market maker” or specific individual.

However, you usually pay a small Trading Fee for the swap, perhaps 0.3%. This fee is not mostly taken by the DEX platform (like Uniswap itself).

Where does this fee go?

It gets added back into the liquidity pool and is then distributed proportionally among all the Liquidity Providers (LPs) who contributed funds to that specific pool.

This is why people are willing to put their crypto into pools as LPs — every time someone trades using that pool, the LPs earn a small share of the fees. It adds up and becomes a source of income. That’s their reward for providing liquidity.

(A side note for the curious: While LPs earn fees, there are risks, primarily “Impermanent Loss” (IL). Briefly, this means if the prices of the two tokens you deposited diverge significantly, the total value when you withdraw might be slightly less than if you had simply held the original tokens separately. But that’s another topic for another day.)

4. Let’s Summarize

• Liquidity Pools are like “shared vaults” or “self-service swap shops” containing pairs of tokens, collectively provided by many LPs.
• When you swap tokens on a DEX using a pool, you are trading directly with the pool. You put your coins in, and the pool gives you the other coins based on its rules.
• Your money (the coins you paid) goes into the pool; the money you want (the coins you receive) comes from the pool.
• The trading fees generated are distributed to all the LPs as a reward for providing their capital.

Next time you trade on a DEX, you’ll know that these liquidity pools are working silently behind the scenes to make your swaps smooth and instantaneous! Hopefully, the world of DeFi feels a bit clearer now!

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