What are Liquidity Pools?
Liquidity pools are smart contracts that hold pairs of tokens and enable trading. They are the backbone of Uniswap and other decentralized exchanges, replacing traditional order books.
Key Concepts
Pool Ratio
The ratio of tokens in a pool determines the exchange rate for trades.
Trading Fees
Liquidity providers earn fees from trades proportional to their pool share.
Becoming a Liquidity Provider
To become a liquidity provider (LP):
- Select a token pair to provide liquidity for
- Deposit equal values of both tokens
- Receive LP tokens representing your pool share
- Start earning fees from trades in that pool
Understanding Impermanent Loss
Impermanent loss occurs when the price ratio of deposited tokens changes compared to when they were deposited. This can result in having less value than if you had simply held the tokens.
Risk Management
Consider these factors before providing liquidity:
- Token pair volatility
- Trading volume and potential fee earnings
- Time horizon for investment
- Gas costs for entering and exiting positions
Concentrated Liquidity (V3)
Uniswap V3 introduced concentrated liquidity, allowing LPs to:
- Provide liquidity within specific price ranges
- Earn higher fees with the same capital
- Customize their risk/reward profile
- Actively manage their positions