What is a liquidity pool?
A liquidity pool is a stock of two tokens held by a smart contract that traders swap against. On a decentralized exchange it replaces the order book: an automated market maker (AMM) sets the price from the ratio of the two reserves. The depositors, called liquidity providers, earn the trading fees. The German term is Liquiditätspool.
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Liquidity pools in brief
| Term | Liquidity pool; its depositors are liquidity providers (LPs). German: Liquiditätspool. |
|---|---|
| Pricing rule | Constant product formula x * y = k, where x and y are the reserves of the two tokens (Uniswap documentation). |
| A number | Traders on Uniswap v2 pay a fee of 0.30% per trade, which goes to the liquidity providers (Uniswap v2 white paper, March 2020). |
| Risk for providers | Impermanent loss (BIS, ). |
| EU law | Operating a trading platform for crypto-assets is a crypto-asset service under Article 3(1)(16)(b) of Regulation (EU) 2023/1114 (MiCA), applicable from . |
| Supervisors | BaFin in Germany, FMA in Austria, FINMA in Switzerland. |
How does a liquidity pool compare with an order book?
A liquidity pool sets the price from its reserves, while an order book sets it from the orders of buyers and sellers. A stock exchange uses a central limit order book: orders are sorted by price and filled as demand shifts, and a market maker posts buy and sell quotes. The BIS explains why DeFi does without it: on a blockchain, "the sheer volume of orders would render the management of an on-chain limit order book very costly".
| Feature | Order book | Liquidity pool (AMM) |
|---|---|---|
| Counterparty of a trade | Another buyer or seller | The pool itself |
| Price | Best bid and best offer in the book | Ratio of the two reserves |
| Who supplies liquidity | Market makers and other traders with limit orders | Anyone who deposits both tokens |
| Where it runs | Exchange systems; crypto exchanges keep the book off-chain | A smart contract on a blockchain |
The Uniswap documentation sums up the AMM vs order book difference: "a trader interacts with the pool directly instead of matching against another user's posted order."
How do liquidity pools work on Uniswap?
Liquidity pools on Uniswap work with the constant product formula x * y = k. Here x and y are the reserves of the two tokens, and k "must stay constant (or increase) after every trade". A trader who takes token y out of the pool must put enough of token x in to keep the product at k.
The price before a trade is the ratio of the two reserves (Uniswap v2 white paper). Larger trades relative to the size of the pool move the price more; the documentation calls this price impact. When the pool price drifts away from other markets, arbitrageurs trade against the pool, so its price "tends to track the relative market price of the assets". In Uniswap v2 the 0.30% fee stays in the pool, and k grows with the collected fees.
That is the AMM meaning in crypto explained in short: for a trader, a liquidity pool means a smart contract that quotes a price for any trade size from a formula, with no human market maker.
What is a liquidity provider, and what are liquidity pool tokens?
A liquidity provider is anyone who deposits both tokens of a pair into a liquidity pool. The BIS describes the rule: the provider deposits the two tokens in proportion to their values in the pool, and "the liquidity-provider's claim on the pool is proportional to its contribution".
Liquidity pool tokens are the receipts for that claim. Uniswap v2 "mints fungible ERC-20 pool tokens representing a proportional share of reserves". In Uniswap v3 and v4, each provider chooses a price range, and v3 represents a position as a non-fungible token (NFT). The provider returns the pool tokens to withdraw the share, including the fees earned.
What is impermanent loss?
Impermanent loss is the shortfall of a liquidity provider against simply holding the two tokens, after their relative price has moved. The BIS explains it: providers "can suffer losses if the relative price of the two cryptoassets on other exchanges diverges substantially from that implied by the bonding curve".
The loss is realized when traders withdraw the token that has gained in value, which leaves the providers worse off than if they had kept their tokens outside the pool. The trading fees "may not be high enough to offset this loss".
Is a liquidity pool safe?
A liquidity pool carries market and code risks, and no deposit guarantee covers it. Besides impermanent loss, the BIS names front-running. Orders wait in a public memory pool before a validator adds them to a block, so another trader can place a buy just before a large order and a sell just after it. The code of the pool is a smart contract, and an error in it executes as written.
ESMA counts maximal extractable value and flash loan attacks among the new forms of market manipulation in DeFi (ESMA, ). This page names no return rate for any pool.
Liquidity pools in Germany, Austria and Switzerland
In Germany and Austria MiCA applies directly. The operation of a trading platform for crypto-assets and the exchange of crypto-assets for other crypto-assets are crypto-asset services under Article 3(1)(16), and a firm that provides them needs an authorization under Article 59. Services provided "in a fully decentralised manner without any intermediary" fall outside MiCA (recital 22). Whether a pool or its front end has an intermediary is a question for the single case. BaFin supervises in Germany, the FMA in Austria.
Switzerland is outside the EU, so MiCA does not apply there. FINMA judges tokens, including pool tokens, by their "economic function and purpose" (FINMA, ). This page gives no legal advice.
Sources
- Uniswap Labs: How Uniswap works, documentation, read
- Hayden Adams, Noah Zinsmeister, Dan Robinson: Uniswap v2 Core, white paper, March 2020
- Bank for International Settlements: DeFi risks and the decentralisation illusion, with Box A "Trading in the DeFi era: automated market-makers", BIS Quarterly Review,
- European Securities and Markets Authority: Decentralised Finance in the EU: Developments and risks,
- FINMA: FINMA publishes ICO guidelines,
- European Union: Regulation (EU) 2023/1114 on markets in crypto-assets,