What Are Liquidity Pools?

Last Modified:
March 1, 2024

Liquidity pools in cryptocurrency are pools of tokens locked in a smart contract that provide the necessary liquidity for trading pairs on decentralized exchanges (DEXes) and lending platforms. In traditional finance, third-party financial institutions provide liquidity, or availability of tokens to trade with. Meanwhile, in decentralized finance, peer-to-peer trading takes place through smart contracts and liquidity pools.

Here’s a breakdown of how they work:

Liquidity pools consist of trading pairs made up of two tokens to be exchanged for each other. For example, a liquidity pool might contain equal values of Ethereum (ETH) and Bitcoin (BTC). The tokens in a liquidity pool are managed by smart contracts, which automatically execute trades without the need for a middleman.

Users who deposit tokens in liquidity pools are called liquidity providers. They receive tokens that represent their share of the pool and give them the right to a portion of the total profit the liquidity pool collects from trading fees. 

Many DEXs use automated market makers (AMM), or smart contracts that use algorithms to determine the price of tokens in a liquidity pool based on the supply and demand of the tokens deposited.

Advantages of Liquidity Pools

  • Decentralization: Users can directly trade and lend tokens without relying on a centralized financial institution to manage the trades and provide the liquidity needed.
  • Instant Trades: Users can trade tokens instantly without waiting for available buyers or sellers.
  • Passive Income: Individual liquidity providers can earn passive income through yield farming, or the process of contributing tokens in a liquidity pool to earn rewards. These rewards are typically paid out in the protocol's governance token

Disadvantages of Liquidity Pools

  • Impermanent Loss: Occurs if the value of the tokens in a pool changes compared to when they were initially deposited. When liquidity providers withdraw their tokens from the pool, especially during unfavorable market conditions, they may receive a different allocation of tokens than what they initially contributed. This discrepancy in token value can result in a loss for liquidity providers, hence the term "impermanent loss."
  • Smart Contract Vulnerabilities: The smart contracts used by liquidity pools are not immune to bugs or security breaches due to poorly written software code.
  • Slippage: In pools with low liquidity, large trades can have a huge impact on the price of a token. This causes users to receive a smaller amount of tokens than they originally expected when executing the trade.

One example of a liquidity pool is the KTX.finance liquidity pool (KLP), a multi-asset pool that allows users to buy and stake tokens to provide liquidity and earn rewards. KTX gives out high yields in $BNB/ETH and $esKTC, offering liquidity providers a possible source of passive income.

Compared to many other liquidity pools which make liquidity providers in each specific pool cover the profits of traders, KTX houses all the assets within a single pool and shares traders’ profits evenly across liquidity providers. This lowers the risks for each liquidity provider and is a more sustainable model in the long run. It also makes integrations with multiple protocols much easier since there is only one liquidity pool to connect with.

Check out our other guides to learn more about crypto trading and staking!