Liquidity Pool

A liquidity pool is the reserve of tokens that an automated market maker trades against. Users called liquidity providers deposit equal values of two tokens, for example 1 ETH and 2,000 USDC, and receive LP tokens representing their share of the pool. Every trade through the pool pays a fee, commonly 0.3 percent, that is added to the reserves and split among providers in proportion to their share.

The size of a pool determines how well it handles large trades. A pool with 100 million dollars of liquidity can absorb a 1 million dollar swap with about 1 percent price impact. A pool with 100,000 dollars would be moved dramatically by the same trade. Deep pools are therefore a sign of a healthy market for a token.

Providing liquidity carries risk. If one token's price changes sharply relative to the other, the provider ends up holding more of the weaker asset, an effect known as impermanent loss. Pools for brand-new tokens can also be drained in a rug pull if the project retains control of the liquidity. Checking whether liquidity is locked is a basic safety step.