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Liquidity Pool
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A liquidity pool is a collection of cryptocurrency funds locked in a smart contract that enables trading and earning on decentralized exchanges.
Simple Explanation
Imagine a pool filled with two types of tokens (like ETH and USDC). When people want to trade, they swap tokens from this pool. People who add tokens to the pool (liquidity providers) earn fees from every trade.
How It Works
- Liquidity providers deposit token pairs (e.g., ETH + USDC)
- Traders swap tokens using the pool
- Pool charges fees on each trade (typically 0.3%)
- Fees are distributed to liquidity providers proportionally
Benefits
- Earn passive income from trading fees
- Enable trading without order books
- Always available liquidity for traders
Risks
- Impermanent Loss: Value can decrease relative to just holding
- Smart Contract Risk: Bugs or hacks
- Market Volatility: Price swings affect returns