A liquidity pool is a smart contract holding reserves of two or more tokens, enabling decentralized trading without traditional order books. Instead of matching buyers with sellers, automated market makers use liquidity pools to execute trades algorithmically. Traders swap against the pool; the pool adjusts prices based on the ratio of its reserves. Liquidity providers deposit equal values of both tokens and earn trading fees proportional to their share of the pool. If ETH/USDC pool has 1000 ETH and 2,000,000 USDC, the implied price is $2,000 per ETH. A large buy of ETH pushes the price higher as ETH leaves and USDC enters, moving the ratio. This constant product formula (x * y = k) ensures the pool never fully depletes. Liquidity pools power DeFi: every DEX swap, every yield farming strategy, every lending protocol relies on them. The main risk for providers is impermanent loss. When the price ratio of deposited assets changes, providers can end up with less value than if they'd held the tokens outright. The greater the price divergence, the greater the impermanent loss.
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