What Is a Liquidity Pool?
Instead of matching buyers and sellers, a DEX uses a pool of tokens. Want to swap USDC for SOL? You trade against a SOL/USDC pool. The pool's balances and an AMM formula determine your price. LPs supply the tokens that make this possible.
How AMMs Set Prices
The classic AMM uses x · y = k: the product of the two token balances stays constant. Buying SOL removes it from the pool and adds USDC, shifting the price. Larger trades move price more — that's price impact. Concentrated liquidity (e.g., Orca Whirlpools) makes capital far more efficient.
LP Tokens & Earning Fees
When you deposit, you receive LP tokens representing your share. Every swap charges a fee that accrues to LPs proportionally. Withdraw by burning your LP tokens to reclaim your share plus earned fees.
Impermanent Loss Explained
Impermanent loss happens when the pool's token prices diverge: you may end up with less value than if you'd simply held. Fees can offset it, but volatile pairs carry more risk. It becomes "permanent" only when you withdraw at a loss.
Summary
Liquidity pools replace order books with token reserves priced by AMM math. LPs earn fees for providing liquidity but must weigh impermanent loss, especially on volatile pairs. Every Jupiter swap ultimately taps these pools — so understanding them is core DeFi literacy.
Frequently Asked Questions
How do liquidity providers make money?
LPs earn a share of the trading fees generated by their pool, proportional to their deposit. Some pools add extra token incentives (farming).
What is impermanent loss?
It's the opportunity cost when pooled token prices diverge versus simply holding them. Trading fees may or may not offset it.
Is providing liquidity risky?
Yes. Beyond impermanent loss, there's smart-contract risk and the risk of holding volatile assets. Research pools carefully.