What Are Liquidity Pools? How DeFi Trading Works Without an Order Book

The Problem Liquidity Pools Solve

In traditional finance and on centralised cryptocurrency exchanges, trading relies on order books, lists of buy and sell orders placed by individual traders and market makers, matched by a central engine.

This model requires active participants on both sides of every trade, and it depends on professional market makers to provide consistent liquidity. Without them, spreads widen, slippage increases, and trading becomes impractical for less popular assets.

DeFi needed a different approach. Running an order book on a blockchain is prohibitively expensive, every order placement, cancellation, and modification would require a transaction and gas fees, making the rapid order updates that market makers rely on economically impossible.

Liquidity pools, the solution: a mechanism that replaces human market makers and order books with smart contracts and mathematical formulas, enabling anyone to trade any supported token pair at any time without relying on a counterparty being present.

How Liquidity Pools Work

A liquidity pool is a smart contract that holds reserves of two or more tokens and enables trading between them using a pricing algorithm. In the simplest and most common design, popularised by Uniswap, a pool holds a pair of tokens (for example, ETH and USDC) and uses the constant product formula to determine prices: x multiplied by y equals k, where x and y are the quantities of each token and k is a constant.

When a trader wants to swap ETH for USDC, they send ETH to the pool and receive USDC from it. The formula ensures that as the supply of ETH in the pool increases (because the trader added some), the supply of USDC decreases (because the trader received some), and the price adjusts accordingly.

The more of one token that is removed relative to the other, the more expensive it becomes, a natural supply-and-demand mechanism encoded in mathematics.

This design is called an Automated Market Maker, or AMM, because the smart contract itself acts as the market maker. It is always willing to trade, always has a quoted price, and never goes offline.

The price it offers adjusts continuously based on the ratio of tokens in the pool, which in turn is driven by trading activity. When the pool price diverges from the broader market price, arbitrageurs step in to trade the difference, pushing the pool price back into alignment, a self-correcting mechanism that keeps AMM prices in sync with the wider market.

Providing Liquidity: How Users Earn Fees

Liquidity pools need tokens to function, and those tokens come from liquidity providers (LPs), users who deposit their tokens into the pool in exchange for a share of the trading fees the pool generates.

When you provide liquidity to an ETH/USDC pool, you typically deposit both tokens in a ratio that matches the current pool price. In return, you receive LP tokens as a receipt that represents your proportional share of the pool.

Every time someone trades through the pool, they pay a small fee that is commonly 0.3 per cent of the trade value, though this varies by protocol and pool. Further on, that fee is added to the pool's reserves, increasing the value of all outstanding LP tokens.

When you eventually withdraw your liquidity by burning your LP tokens, you receive your proportional share of the pool's total assets, which now includes accumulated fees.

The yield that LPs earn depends on two factors: the fee percentage and the trading volume relative to the pool's size. A pool with USD 1 million in liquidity that processes USD 500,000 in daily trading volume generates significantly more fee income per LP token than a pool with the same liquidity but only USD 10,000 in daily volume.

This is why liquidity providers gravitate toward pools with high volume-to-liquidity ratios, they offer the best returns on deposited capital.

Impermanent Loss: The Key Risk for Liquidity Providers

Impermanent loss is the most important concept for anyone considering providing liquidity to understand. It occurs when the price ratio between the two tokens in a pool changes from the ratio at the time you deposited.

Due to how AMMs work, the pool automatically rebalances, selling the token that is increasing in price and accumulating the token that is decreasing. This means that when you withdraw, you end up with more of the cheaper token and less of the more expensive one compared to simply holding both tokens in your wallet.

The math is straightforward but the implications can be significant. If one token doubles in price relative to the other, an LP position experiences approximately 5.7 per cent impermanent loss compared to simply holding both tokens.

If one token quadruples, the loss rises to about 20 per cent. At extreme divergences, one token doing 100x relative to the other, impermanent loss can reach 50 per cent or more of the position's value.

The term "impermanent" reflects that the loss only becomes realised when you withdraw your liquidity. If the price ratio returns to what it was when you deposited, the impermanent loss disappears entirely.

However, in practice, prices rarely return to exactly the same ratio, and many LPs withdraw at a loss. This is why the DeFi community increasingly refers to it as "divergence loss", a more accurate term that does not imply the loss is temporary.

The trading fees they earn must exceed their impermanent loss for LPs to be profitable. Pools with high trading volume relative to their size (generating substantial fees) and pools with correlated assets (experiencing less price divergence) tend to be the most profitable for liquidity providers.

Stablecoin pairs like USDC/USDT are popular LP positions precisely because the price ratio barely moves, making impermanent loss negligible while fees still accumulate.

Concentrated Liquidity: The Evolution

Traditional liquidity pools spread their capital evenly across the entire price range from zero to infinity. This means that for an ETH/USDC pool, the majority of the deposited capital sits at price ranges that are never actually used in trading.

There is capital allocated for the scenario where ETH trades at USD 0.01 or USD 1 million, even though actual trading occurs in a much narrower range.

Concentrated liquidity, introduced by Uniswap V3 in 2021, allows LPs to specify a price range within which their liquidity is active.

Instead of providing liquidity across all possible prices, an LP might choose to provide liquidity only for the ETH/USDC range between USD 2,500 and USD 4,000. Within that range, their capital provides much deeper liquidity (and earns proportionally more fees) than the same amount would in a traditional full-range pool.

The trade-off is complexity and increased impermanent loss risk. If the price moves outside a concentrated LP's chosen range, their position becomes inactive. As a result, it earns zero fees and is entirely composed of the cheaper token.

Managing concentrated liquidity positions requires active monitoring and adjustment, which is why automated vault protocols like Arrakis Finance, Gamma Strategies, and Kamino Finance (on Solana) have started to manage these positions on behalf of users.

Different AMM Designs for Different Purposes

Not all liquidity pools use the same pricing formula. The constant product formula (x times y equals k) is the simplest and most general-purpose, but specialised AMM designs have been developed for specific use cases.

Curve Finance innovated the StableSwap invariant, a formula optimised for trading between tokens that should be approximately equal in value, like stablecoins (USDC, USDT, DAI) or liquid staking derivatives (ETH, stETH, rETH).

The StableSwap curve concentrates liquidity around the 1:1 price ratio. So when the prices diverge, this enables extremely low-slippage trades between correlated assets while still functioning as a standard AMM.

Balancer introduced weighted pools, where tokens do not need to be deposited in equal ratios. A pool might hold 80 per cent ETH and 20 per cent USDC, reducing the impermanent loss exposure for LPs who have a directional view on one asset.

On top of that, Balancer also supports multi-token pools (up to eight tokens), functioning like an automatically rebalancing index fund.

More recent innovations include Maverick Protocol's directional liquidity , where LPs can specify that their liquidity should follow the price in a particular direction. Next, Trader Joe's Liquidity Book model, which uses discrete price bins rather than a continuous curve. Lastly, Fluid's approach of using lending positions as DEX liquidity.

Each design represents a different set of trade-offs between capital efficiency, impermanent loss, complexity, and the specific trading use case being served.

How to Evaluate a Liquidity Pool

Before providing liquidity to any pool, several factors warrant analysis. Trading volume relative to pool size is the primary driver of LP returns. A useful benchmark is whether daily volume exceeds 5 per cent of total pool liquidity, as pools above this threshold tend to generate enough fees to offset impermanent loss from moderate price movements within 30 days.

The correlation between the paired tokens matters significantly.

Highly correlated pairs (stablecoin-stablecoin, ETH-stETH) have minimal impermanent loss.

Moderately correlated pairs (ETH-WBTC) have moderate risk.

Uncorrelated or inversely correlated pairs (ETH-memecoin) carry the highest impermanent loss risk and should only be considered if fee income is exceptionally high.

Protocol risk varies across AMMs. Established protocols like Uniswap and Curve have years of battle-testing, while newer AMM designs may offer higher yields but carry more smart contract risk.

The chain the pool operates on also matters. For instance, pools on Ethereum mainnet incur higher gas costs for deposits and withdrawals, which can eat into returns on smaller positions. While, Layer 2 pools and pools on chains like Solana have lower friction costs.

Finally, consider incentive programmes. Many protocols offer additional token rewards to LPs beyond trading fees. While these can boost returns significantly, they often decrease over time as emissions reduce, and the rewarded tokens may themselves lose value.

Sustainable LP returns should be evaluated based on trading fees alone, with incentive rewards treated as a temporary bonus rather than a guaranteed component of yield.

Liquidity Pools and Portals.fi

Portals.fi is a DeFi aggregation platform that allows users to access liquidity pools across multiple protocols and chains through a unified interface. Users can compare yields, enter and exit LP positions, and manage their DeFi portfolio from a single access point.

For more information about how Portals.fi works, visit portals.fi.

This article is for informational purposes only and does not constitute financial advice. Providing liquidity to DeFi protocols carries risks including impermanent loss, smart contract vulnerabilities, and market volatility. Always conduct your own research before depositing funds into any liquidity pool. For our full disclaimer, please visit here.