July 28, 2025

10 min

Exploring Crypto Liquidity Pools: How They Work & Why They Matter

In the world of cryptocurrency and decentralized finance (DeFi), liquidity pools play a pivotal role in enabling seamless trading and earning opportunities. If you’re a beginner searching for liquidity pools explained, what is a crypto liquidity pool, or how adding crypto assets to them can earn you crypto rewards, you’re in the right place.

This friendly guide will demystify crypto liquidity pools, explain how liquidity pools work, and why they matter in the world of DeFi.

What Is a Liquidity Pool?

A liquidity pool at its core is a digital reservoir of crypto assets locked in a smart contract, enabling decentralized trading and providing liquidity for all users.

Liquidity pools are primarily used to facilitate trading on decentralized exchanges (DEXs) e.g. Uniswap, PancakeSwap or SushiSwap.

Before we dive into exchanges and trading, let’s start with bank accounts. When you deposit money into a bank, the bank doesn’t just let it sit there. It lends it out, invests it, and earns profits. In return, you get a fraction of a percent of those profits as interest.

Now, imagine a system that works without the bank at all. In decentralized finance (DeFi), you can deposit your crypto into something called a liquidity pool. Other people then can use the pool to trade between cryptocurrencies, and every time a trade happens, the system charges a small fee, a share of which goes to you. So while a bank pays you interest from loans it controls, a liquidity pool pays you fees from trades it enables.

Liquidity pools are crypto funds locked in a smart contract to enable trading on a DEX.

Let’s break that down with one consistent metaphor—the vending machine:

Smart contract ＝ vending-machine brain A smart contract is the code that tells the machine exactly what to do. Once programmed, no one can sneak in and change the prices or jam the buttons. It runs automatically whenever the right inputs (your coins) arrive.
DEX (decentralized exchange) ＝ a hall of vending machines Instead of a single cashiered kiosk, a DEX is a room full of automated machines. Anyone can walk up, insert tokens, and instantly swap for something else—no human clerk, no bank, no paperwork.
Liquidity pool ＝ the machine’s stockroom Inside each machine sits a stash of different crypto assets. The smart contract’s algorithm adjusts prices on the fly: if users keep buying one token, its shelf empties and the price ticks up; if they add more of that token, the price eases back down. This dynamic keeps trading possible even when demand shifts.
Liquidity providers ＝ the restockers People who deposit tokens into the pool refill the machine. They also get a small cut from each swap (like restocking fees). This setup ensures crypto liquidity pools always have some assets available for exchange, making trading quick and decentralized.

Because the entire process is automated and transparent, users can trade 24/7, and there’s always “something in the machine” to buy or sell.

How Do Liquidity Pools Work

Liquidity providers (LPs)

Liquidity providers (LPs) who fund the pool with their crypto assets are crucial to this system. When they deposit their tokens, the smart contract usually issues them LP tokens (liquidity provider tokens) representing their share of the pool. It’s a bit like holding a stake in a company with share ownership. You can later redeem these liquidity pool tokens and get back your share of the pool’s assets plus any accrued trading fees.

Token Swapping

When you trade in a liquidity pool, for example a pool with ETH and USDC you're either:

Adding ETH and removing USDC (selling ETH)
Removing ETH and adding USDC (buying ETH)

In other words, you are either swapping your ETH for USDC on the pool, and therefore you are selling ETH. Or you are swapping your USDC for ETH on the pool and are buying ETH.

Automated Market Makers (AMMs)

Unlike traditional exchanges, where order books and third parties determine the price of an asset based on demand and supply, in liquidity pools this process is automated. Liquidity pools use a smart contract, an Automated Market Maker AMM, to calculate the price of an asset based on supply and demand. .

Using our example of a liquidity pool containing ETH and USDC, the AMM manages the price of ETH so that the less ETH is in the pool the more its price goes up, because more people are buying from the pool than selling. As opposed to an increase of ETH in the pool, which lowers its price, because more people are selling ETH than buying it. AMM Automated Market Maker

To continue our example of ETH and USDC.

Let’s say the pool holds 100 ETH and 200,000 USDC, meaning the price at that moment is 1 ETH = 2,000 USDC. Now, imagine Alice is selling 10 ETH to the pool in exchange for USDC. After the trade:

The pool now holds 110 ETH because Alice sold 10 ETH to the pool.
And 180,000 USDC, because Alice in return received 20,000 USDC in return for her ETH.

Now, there is more ETH in the pool compared to USDC. Therefore the price of ETH is recalculated automatically by the AMM and ETH becomes cheaper.

In the previous example, Alice sold only 10 ETH to the pool. But if Bob came along and sold 50 ETH, this swap would shift the proportion of ETH to USDS dramatically and would send the price of ETH to USDS crashing. This phenomenon is called slippage, because the price of the crypto asset slips, and often it slips crashing down onto the floor. This is usually avoided by choosing a pool with a large volume of cryptocurrency on it, metaphorically named in the crypto world: a deep liquidity pool. Such pools are more difficult to manipulate because they are more stable, even with larger purchases or sales of crypto assets done on them. Crypto liquidity pools rely on automated market makers (AMMs) to keep everything moving smoothly. These systems show exactly how liquidity pools work, allowing users to swap tokens directly from the pool without a third party.

CEX vs DEX: A Quick Comparison

To make sense of liquidity pools, it helps to contrast them with how centralized exchanges (CEXs) operate.

🔄 Price Discrepancies and Arbitrage

Because a centralized exchange, such as Coinbase, calculate the price of a crypto asset like ETH using order books and a third party, while decentralized exchanges like SushiSwap use AMMs, this sometimes means a trader can find a better price on a pool for a certain cryptocurrency and buy it at a bargain price. These traders are called arbitrage traders, who will often then sell that purchase at another market at a higher price and pocket a profit. Usually, such traders help bring back upwards a price of a crypto asset in a pool in line with usual market prices.

Earning Fees

Every time somebody trades using the pool (swaps tokens), they pay a small fee (like 0.3%). That fee goes back into the liquidity pool and accrues over time. Your liquidity tokens represent a fixed percentage of that pool. But unlike holding shares which would pay you dividends every quarter. In liquidity pools you receive your entitled shared profit only when you cash out.

Comparison to Shares in a Bakery Company

🧁 Your ownership percentage doesn’t change, but the value of what you own does — because the “bakery” keeps stuffing more profits into the vault.

So when you withdraw your liquidity (i.e cash out), you receive:

✅ Your original share of tokens

✅ Your proportional cut of all the fees collected while you were in the pool

Your slice of the pie doesn’t get bigger — the pie itself does. And when you’re ready, you take your slice out, frosting and all.

Liquidity pool explained in simple terms: You deposit assets, receive a share of fees, and benefit from providing liquidity to the DeFi pool while growing the value of your holdings.

We’ve covered how liquidity pools work. By now, terms like AMM, LP tokens, and token swapping should feel a bit more familiar. But let explore now why liquidity pools matter so much, and the rewards and risks to an in

Why Liquidity Pools Matter in DeFi?

Liquidity pools are the backbone of DeFi trading. They create Decentralization and Open Access: By removing the need for middlemen like centralized exchanges or professional market makers to facilitate trades. Anyone can participate as a liquidity provider or trader without permission.

Providing Liquidity: Rewards and Risks

The Good Stuff:

When you provide tokens to a liquidity pool (often called staking liquidity or just LPing), you typically enjoy these benefits:

Trading Fee Income: This is the primary incentive. Each time someone trades in the pool, a fee (commonly 0.3% of the trade) is split among LPs. Over time, these fees can accumulate and significantly boost your initial holdings.
Supporting the Ecosystem: Beyond personal profit, many enjoy being an LP to help a project’s community. By adding liquidity, you’re improving market stability for that token pair. This can be seen as a service to fellow traders (while you earn a reward). It’s a win-win when done properly: traders get low-slippage trades, and LPs get compensated for enabling that. So instead of just earning fees from your pool, your LP token becomes a key that unlocks more ways to earn. That’s the “stacking” part — like building new layers on your LEGO creation.

Now for the Risks

“This sounds great — I can earn fees by providing liquidity. What’s the catch?”

Good question.

Let’s break it down: Providing liquidity, also known as being a liquidity provider, involves depositing your tokens into a defi pool or a liquidity pool crypto platform and earning rewards in return. We’ve covered that. But there are some risks you should be aware of.

Impermanent Losses - Murphy’s Law meets crypto volatility

The first risk is also one of the most common, and is due to the market. Which is why we’re explaining it first!

Let’s say there is a point in time the AMM has calculated your assets in the liquidity pool to be worth less than the market value. If at that exact moment you withdrew your money, you would incur a loss.

However, if you hung on a bit longer, the market would rebalance the price of those assets in the pool. Thus minimising your loss. This is why this risk is named impermanent loss because it is “impermanent” — meaning it is not set in stone.. Curious to see the math and real-world examples? Kraken's explainer is super beginner-friendly and worth a look.

A Software Glitch in the AMM

The second risk comes from the AMM itself.Liquidity pools are governed by smart contracts, the AMMs that govern the price of the crypto assets in them according to supply and demand. If there’s a bug or vulnerability in the pool’s code or the DEX platform, funds could be lost or stolen (for example, through hacks or exploits).

While major platforms like Uniswap are battle-tested and open-source (with many eyes auditing them), new or unaudited projects can be riskier. Always ensure you trust the platform’s security record before depositing funds. Remember that DeFi is an innovative space, but not without occasional mishaps.

Low Liquidity Pitfalls:

The third most common risk of liquidity pools, needs a bit more context. It comes into play when the liquidity levels of a pool are too low.If you join a very small pool (low total value locked), let’s say the pool only has 10 ETH and 20,000 USDC, there is a serious risk somebody like Mr Bob could come along and sell 7 ETH on that pool. Thus skewing the proportion of ETH to USDC to record low levels.

The AMM would then adjust the price of ETH on the pool, and its price would slip (hence the term slippage) reflecting this all time low. It’s because of this low-liquidity pools are more sensitive to price manipulation. It’s generally safer (especially for newbies) to provide liquidity in larger, well-established pools, AKA deep liquidity pools.

This is why liquidity in crypto is essential—without enough assets in a liquidity pool, it becomes much harder for users to buy or sell tokens without major price changes. Deep liquidity pools help keep trades smooth and prices stable. However, this is not to say that even basic liquidity pools are critical for enabling any trading activity in the DeFi ecosystem.

Alternatives

Bitcoin Mining

While liquidity pools are a big part of DeFi, they’re not the only way to earn in crypto. There is also Bitcoin mining. Is Bitcoin mining profitable? It all depends, when it comes to bitcoin mining there is a steep learning curve and you will need deep pockets, but GoMining offers an easy alternative. Digital mining is a much easier alternative. GoMining walks you through how to find a real bitcoin mining app before you spend a single satoshi. If you are familiar with digital mining but want to know more, and how it differs from cloud mining in this blog post digital miner vs. cloud mining.

GoMining is more than a Bitcoin mining app—it’s a full-featured ecosystem that brings the power of real-world data center hashpower to your fingertips. And mining is just the opening act. GoMining layers on game-style quests, community challenges, and its adrenaline-pumping Miner Wars arena, transforming hash-rate spreadsheets into a full-blown, play-to-earn adventure where every block you win feels like a level-up. It is the perfect combination of mining games online and mining Bitcoins.

Dive deeper by browsing the curated digital miner collections, each paired with eye-catching GoMining digital avatars that visualise your share of real hash-rate. The app also has its built-in bitcoin mining calculator crunches payout forecasts, so you can estimate your return on investment in seconds.

Finally, GoMining’s ecosystem layers in token-fuelled perks and play-to-earn fun. The GoMining token anchors the platform’s crypto tokenomics, unlocking fee discounts via the tiered GoMining VIP loyalty program

Staking

Blockchains like ETH and Solana use a Proof-of-Stake (PoS) blockchain network to run smoothly . Staking is when you lock up your cryptocurrency to help keep a blockchain network running smoothly. In return, you earn rewards — kind of like earning interest. Most people stake through a staking pool.

Or…If You’re Feeling Adventurous: Let Your Tokens Work Overtime

In DeFi, everything is built to connect together — kind of like LEGO bricks. This ability to mix and match parts is called composability. This means you can combine your Liquidity tokens to other blockchain tools, like lego and earn more money…if you are really savvy and know what you are doing.

Deposit your GoMining tokens in a liquidity mining pool and earn more. In this case you will be earning your btc mining rewards, and a percentage from the accrued fees on the pool.
A popular way of using your LP tokens is depositing them in a yield compounder (sometimes known as a yield farm). Yield farming is a way to earn further interest on your crypto.

Conclusion: Liquidity Pools & Your Crypto Journey

Should you jump in and become a liquidity provider? If you have assets you believe in long-term and want to earn some yield on them, liquidity pools offer a way to do that while contributing to the crypto liquidity pools ecosystem and the broader DeFi pool revolution.