A liquidity pool is a smart contract that holds two or more tokens in a paired reserve. Liquidity providers (LPs) deposit balanced amounts of the paired assets. Traders swap against the pool; each trade shifts the ratio, and the contract computes the output price algorithmically.
The canonical formula is Uniswap V2's `x * y = k`: the product of the two balances stays constant (minus fees). Push 10 ETH in, the pool takes more USDC out than the spot price would suggest for a trivial trade, because the ratio has shifted. This is **price impact**.
Why LP: - Earn a share of the swap fees (0.05%, 0.3%, or 1% on Uniswap, depending on pool). - Participate in the market without taking directional risk (theoretically — but see below).
Why NOT to LP: - **Impermanent loss** — when the price of one asset in the pair moves relative to the other, LPs end up with more of the underperforming asset. For volatile pairs this loss often exceeds fee earnings. - **Smart-contract risk** — if the DEX contract is exploited, LP funds are at risk. - **Rug-pull risk** on obscure token pools — legitimate-looking projects have drained LP pools by withdrawing all liquidity and disappearing.
Concentrated liquidity (Uniswap V3+) lets LPs specify a price range within which they provide liquidity. More fee income per dollar deposited when the market stays in range; sharp losses when it moves outside.