The Essence and Utilization Guide of Pool Liquidity in Cryptocurrency

DYORMaster · 2025-12-21T12:23:50+00:00

This essay explores the essentials of liquidity pools in decentralized finance (DeFi), detailing their structure, functions, and the potential risks involved while highlighting the roles of liquidity providers and automated market makers.

DYORMaster

2025-12-21 12:23:50

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Introduction

As decentralized finance (DeFi) rapidly expands in the blockchain space, one of the mechanisms that supports its core is the liquidity pool. This innovative mechanism enables the realization of a financial system without traditional intermediaries, and we will provide a detailed explanation from its structure to its usage and potential risks.

The Basic Role of Liquidity Pools

A liquidity pool is a collection of multiple cryptocurrencies or tokens deposited into a smart contract, serving as the foundation for providing liquidity to decentralized exchanges (DEXs) and other DeFi applications.

In traditional centralized markets, matching buyers and sellers was necessary for a transaction to occur. However, in liquidity pools, a smart contract known as an Automated Market Maker (AMM) automates this intermediary process. This allows participants to trade directly with the assets in the pool instantly, eliminating the need to search for a counterparty.

Role of Liquidity Pool Participants and Reward Mechanism

Function of Liquidity Providers (LP)

Participants who deposit cryptocurrencies into a liquidity pool are referred to as liquidity providers (LPs). Typically, LPs supply two types of tokens of equivalent value (for example, ETH and USDC) to the pool simultaneously. In return for this contribution, LPs receive LP tokens that indicate their ownership share in the pool.

LP tokens are not just a certificate; they represent a claim to the distribution of transaction fees generated within the pool. Each time a swap transaction is executed, a portion of the fees incurred is automatically allocated to each LP in the pool. This is the source of passive income.

Many platforms also offer yield farming and liquidity mining opportunities by depositing LP tokens into other DeFi protocols, allowing for the diversification of income opportunities.

The mechanism of Automated Market Makers (AMM)

The core of the AMM mechanism is the price determination algorithm. The representative formula used in Uniswap is as follows:

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