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What is a Liquidity Pool, and How to Make Profit from it?

What is a Liquidity Pool, and How to Make Profit from it?
Author: Rakshita Jain

There was a time when crypto investors could only make a profit on their crypto by either trading it on exchanges or adopting a HODL approach for the long term. However, the ever-growing ecosystem of DeFi (Decentralized Finance) has unlocked many ways to earn through your crypto without selling it or keeping it idle, like Staking and Lending.

One such very lucrative way is Liquidity Mining done through Liquidity Pools. Many crypto owners use this innovative way to make money via their crypto assets. And if you also want to try it, read this blog to understand what it is and how it works.

What is a Liquidity Pool?

A Liquidity pool is the collection of different types of cryptocurrencies that provides liquidity to Decentralized exchanges (DEX) for enabling automated trading and other services.

Let’s start from the bottom and work our way up to understand Liquidity Pools in detail.

Liquidity is the ease at which one token can be swapped with another or any fiat currency. In traditional markets like the stock market, this liquidity comes through an order book method where buyers and sellers place orders for assets at specific prices and quantities. Then the stock exchange matches buy orders with sell orders of the same value and quantity. 

Centralized exchanges in crypto also use this same order book method to execute trades and establish prices of cryptocurrencies.

For example, let us assume that seller ‘X’ wants to buy 1 BTC at $1000 and buyer ‘Y’ wants to buy 1 BTC at $1000. Then their trade request will be registered in the order book of the Crypto exchange, and the exchange will match these two orders and execute the transaction of 1 BTC from X to Y at the price of $1000. The Exchange deducts a minimal transaction fee for assisting the trades as a third party.

However, when it comes to Decentralized Exchanges (DEX), they act differently than a third-party centralized market maker due to their decentralized nature. The DEX uses an Automated Market Maker (AMM) protocol that facilitates a trading mechanism between buyers and sellers of crypto assets. But these AMMs also need enough liquidity to function. Otherwise, they can create a large difference in the price of a crypto asset for the trade to execute.

Since DEXs work on a relatively new technology and use a complicated interface, their buyers and sellers are smaller in number, which makes it challenging to generate enough liquidity regularly. The AMM solves this problem by introducing Liquidity Pools where different crypto holders willingly lock their crypto assets to get the incentives. The AMM then uses these locked assets to establish liquidity for its traders.

How do Liquidity Pools work?

The working of Liquidity Pools can be best understood by dividing it into two sections- for Liquidity providers and Traders.

For Liquidity Providers

Any liquidity pool is a collection of two types of cryptocurrencies, creating a new market for that particular pair of currencies. The participants who wish to become the liquidity provider of a liquidity pool deposit an equal amount of these cryptocurrencies.

For example, if you want to participate in a liquidity pool of an X/Y trading pair (where the price of crypto X = price of crypto Y), you need to deposit X and Y in the same proportion so that the ratio between X and Y in the pool is 1:1.

If 10 crypto owners came together to deposit their 100 X and 100 Y tokens each in the pool, the pool got 1000 X and 1000 Y tokens. Once the pool is created after multiple crypto owners deposited their X and Y tokens, DEX traders can use this collection of X & Y tokens to swap their tokens. 

The Liquidity pool charges a transaction fee for each such swap and exchange of tokens. A section of this fee gets distributed to Liquidity providers who have deposited their crypto assets in the pool to provide liquidity. They get their share of the total transaction fees according to their contribution of tokens in the pool.

NOTE: In the above example, we used two equally priced tokens to understand the concept. However, it might only sometimes be the case. The tokens usually are of different prices, and one must deposit an equal value of two tokens in the pool. For instance, if you are depositing $100 worth of ETH, you will also be required to deposit $100 worth of USDT.

For Traders

When a trader comes to the pool to take his 100 X tokens, he will have to deposit 100 Y tokens for the swap (Considering that the price of both tokens is the same). Then the ratio of X and Y in the pool, equal in the beginning, will change. The pool will now have 900 (1000-100) X tokens and 1100(1000+100) Y tokens left after the swap. Due to this change in the number of tokens, their price will no longer stay as the original. The price of the scarcer token, X here, will increase, and the Y token will lower.

In the same way, if another trader comes and deposits 200 X tokens to get 200 Y tokens. Then the final count of X and Y tokens in the pool will change again, making the total count of X tokens in the pool 1100 and that of Y tokens 900. It will again change the price and ratio of both tokens inside the pool.

How to make a profit from a Liquidity pool?

When any Crypto owner deposits two different types of tokens in a liquidity pool, they become the Liquidity provider and receive LP (Liquidity pool) tokens representing their shares in the Pool.

The Liquidity providers can stake these LP tokens and earn additional rewards, usually the native token of the DEX platform where their crypto assets are deposited.

This way, the crypto holders become Liquidity providers in the Liquidity Pool to earn a portion of the trading fee of the pool as well as the staking rewards through their LP tokens.

For Traders

The Traders who come to swap tokens in the liquidity pool can earn through it using the arbitrage difference in the price of tokens in the pool and the other Centralized markets and pools.

What is Liquidity Mining?

Liquidity Mining in Crypto is the process of lending crypto assets to a DEX to earn trading fee rewards. The Liquidity pools in Decentralized exchanges charge a minimal trading fee to traders. The protocol of the lending pool then collects the trading fee of all transactions and distributes them to the liquidity providers as per their shares of deposited tokens.

It provides the opportunity for crypto investors to earn ample interest rewards on their otherwise idle crypto assets. They can generate passive revenue through Liquidity mining without taking trading risks. The yields in Liquidity mining are generally very high compared to other crypto-earning plans. While becoming a Liquidity provider for stablecoins comes with some stability but lower rewards, giving volatile currencies for liquidity involves higher risk and higher rewards.

In addition, the Liquidity providers also earn the native tokens of the Decentralized Exchanges they use. Owning these native tokens gives them governance rights over the decision-making related to the platform. So they can together make significant required changes in the protocols of the platform.

The minimum entry amount for participating in liquidity mining is also lower than many other alternatives to earn rewards on crypto assets. 

Which are the best Liquidity Pools?

Here are some of the best-known Liquidity pools and their information in brief:


Uniswap is a leading name in the list of reliable DEX platforms. It offers liquidity pools for multiple pairs of Ethereum and ERC 20 tokens so that traders can perform decentralized trade between them. Since it's an open-source platform, it attracts many true fans of decentralization who want to launch their new liquidity pools for any token without any fees. The transaction fee that Uniswap charges on transactions is 0.3% which is quite competitive in the market.

The native token of Uniswap is UNI, a very popular DeFi token. Liquidity providers can earn this token by depositing their crypto assets in the liquidity pools of Uniswap.

Curve Finance

The Curve DAO is another well-known name. It operates decentralized Liquidity pools for Ethereum and some stablecoins. Curve provides its native CRV token to its Liquidity providers, trading fees, and other rewards. The presence of ample stablecoins on Curve significantly lowers the chances of price fluctuations and losses due to volatility amid a transaction.


Pancakeswap works very similarly to Uniswap. It rewards liquidity providers with trading fees whenever anyone transacts on their liquidity pool. Any trader who uses Pancake swap pays a 0.25% fee, of which 0.17% adds to the liquidity pool, and the remaining fee gets distributed to the liquidity providers. They can also earn CAKE tokens from Pancakeswap through its Cake Farming program.

Can Liquidity Pools be hacked?

Yes, Liquidity Pools are hackable. As we know, liquidity pools are programs made of codes and algorithms. Thus, bad actors can hack these codes by identifying some undiscovered bugs.

Last year, Uniswap Liquidity Pool suffered a phishing attack in which the assets worth $3.5 million of an Uniswap Liquidity provider got affected.

However, crypto experts consider these liquidity pools very safe to use despite these involved risks. Adopting a risk management strategy is recommended before putting your crypto in any Liquidity pool. 

End Note

Liquidity pools are an emerging profit-earning spot for Crypto investors these days. Their unique algorithm and design make them a win-win for traders and Liquidity providers. With their help, Decentralized exchanges can provide liquidity to their traders without involving any third-party intermediaries. Crypto investors can explore Liquidity mining to participate in these liquidity pools and earn passive rewards on their crypto investments without selling them.

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