The quiet power behind every crypto swap.
When we talked about DEXs back in Day 33, we said they let people trade crypto without banks, brokers, or middlemen. But that freedom raises a big question: if there’s no middleman, then who provides the money to make those swaps possible?
Enter liquidity pools, the invisible engines running every decentralized exchange. They don’t make noise, but without them, DeFi would stop moving.
The problem DEXs had to solve
Imagine walking into a currency exchange shop to swap pesos for dollars.
If there’s no one inside with dollars, you can’t make a trade.
Traditional markets solve this with order books, lists of buyers and sellers waiting for matching prices. But in crypto, that system doesn’t work well for decentralized platforms, where trades need to happen automatically and globally, 24/7.
So instead of waiting for buyers and sellers to meet, DEXs introduced liquidity pools, a shared pot of tokens that anyone can contribute to. These pools make sure there’s always liquidity (money available) when someone wants to swap.
It’s like stocking a vending machine before people start buying. You need supplies first so transactions can flow smoothly later.
What is a liquidity pool?
A liquidity pool is a collection of two tokens locked in a smart contract.
For example:
- The ETH/USDC pool holds Ethereum and USDC.
- The BTC/ETH pool holds Bitcoin and Ethereum.
When you use a DEX like Uniswap or BaseSwap to trade ETH for USDC, your swap happens directly against that pool, not another person. The smart contract automatically adjusts the price based on supply and demand.
The people who provide those tokens are called liquidity providers (LPs), and they earn a share of the trading fees as a reward.
How it works in practice
Let’s say you add liquidity to an ETH/USDC pool. You might contribute ₱10,000 worth of ETH and ₱10,000 worth of USDC, equal value of both tokens.
Now, every time someone swaps ETH for USDC or vice versa, they pay a small transaction fee (often 0.3%). That fee is distributed proportionally among all the liquidity providers.
In exchange for contributing, the platform gives you something called LP tokens, think of them as digital receipts representing your share of the pool.
If you ever want to withdraw your funds (plus earned fees), you return those LP tokens, and the contract gives you back your portion of the pool.
A simple analogy
Think of a liquidity pool like a community bakery.
You and a few friends bring ingredients, flour and sugar, and together, you keep the bakery running.
When customers (traders) come in to buy cookies (swap tokens), a small slice of every sale goes back to the people who supplied the ingredients.
The more ingredients you contribute, the bigger your share of the profits.
But if the price of sugar or flour suddenly changes, your total value might shift too, that’s what we’ll talk about next.
Impermanent loss: the catch nobody warns you about
Liquidity pools sound like easy money, just deposit and earn fees, but they come with a hidden twist called impermanent loss.
It happens when the price of the tokens you added changes compared to when you first supplied them.
For example, imagine you added ETH and USDC to a pool when ETH was ₱100,000. Later, ETH doubles to ₱200,000.
The smart contract automatically rebalances the pool, meaning you now hold less ETH and more USDC, leaving you with slightly lower overall value than if you had just held your ETH.
That’s impermanent loss. It’s called impermanent because if prices return to where they started, the loss disappears. But in volatile markets, it often becomes permanent.
Still, for many liquidity providers, the trading fees they earn can offset that loss, especially in pools with high volume.
Why people become liquidity providers
There are three main reasons:
- Passive income. LPs earn a steady flow of trading fees. It’s not fixed interest, but in active pools, the rewards can be attractive.
- Supporting DeFi ecosystems. By adding liquidity, you’re helping the whole network function. Without LPs, traders can’t swap efficiently.
- Access to farming and bonuses. Some protocols reward LPs with extra tokens through yield farming, we’ll get into that in Day 36.
It’s both a way to earn and a way to participate in the financial plumbing of Web3.
Risks to watch out for
DeFi is open and experimental, which means it’s also risky.
Before becoming an LP, always consider:
- Smart contract risk: If the code has bugs or gets hacked, funds in the pool could be lost.
- Impermanent loss: As we just discussed, price volatility can eat into profits.
- Fake tokens or pools: Scammers sometimes create fake pools to trick users. Always verify token addresses on trusted sites.
The golden rule: never provide liquidity for assets you wouldn’t mind holding long-term.
How to add liquidity (safely)
Here’s how a beginner might do it:
- Open a DEX like BaseSwap or Uniswap.
- Connect your wallet (MetaMask, Trust Wallet, or Rabby).
- Choose the two tokens you want to pair.
- Approve both tokens and confirm the transaction.
- You’ll receive LP tokens, your proof of ownership.
From there, you can either hold your LP tokens and earn trading fees passively, or use them for yield farming in certain protocols.
Always start small, double-check networks, and confirm the pool is verified before clicking anything.
Why liquidity pools matter
Liquidity pools are what make decentralized finance work.
They replace middlemen with math, and institutions with communities.
Every swap on a DEX, every token you buy or sell, relies on the silent cooperation of thousands of people providing liquidity. It’s the closest thing finance has ever had to a public good.
And here’s the best part: anyone can join.
You don’t need to be rich, licensed, or approved. You just need a wallet and a little courage.
The bigger picture
In a way, liquidity pools capture the spirit of Web3 perfectly.
They’re collaborative, transparent, and reward participation.
When you become a liquidity provider, you’re not just chasing yield, you’re taking part in building the foundation for a new kind of financial world.
It’s DeFi at its best: open, experimental, and powered by everyday people who decided to take ownership instead of waiting for permission.
Takeaway
Liquidity pools may sound technical, but their idea is simple:
People come together, lock in value, and keep markets alive.
It’s not about giant institutions anymore, it’s about shared responsibility.
So next time you make a token swap, remember: somewhere, behind that smooth interface, a group of liquidity providers made your trade possible.
Providing liquidity sounds fancy, but it starts with understanding the basics.
Would you ever consider becoming a liquidity provider, or do you prefer simpler ways to earn like staking? Let’s talk about it below.
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