How Liquidity Pools Work and What You Deposit
A liquidity pool is a smart contract that prices swaps with a formula, and providers earn a share of trading fees. You need both tokens and gas.
Vahe HakobyanEditor-in-chief
Updated Oct 6, 20263 min readFact-checked
On this page
- Uniswap launched in 2018 on Ethereum.
- Impermanent loss can reduce your withdrawal value.
- Keep tax records of deposits, withdrawals, and fees.
- A pool contract can have bugs or be drained.
This model became common on Ethereum after 2018. Each trade changes the pool balance and your share of it.
How Does a Liquidity Pool Work?
A liquidity pool is a smart contract that holds a pair of tokens and lets users swap one for the other. Uniswap, launched on November 2, 2018, uses this model on Ethereum. The pool prices each trade with the constant product rule, written as x times y equals a constant. Each swap pays a fee, and liquidity providers earn a share of those fees based on their deposit.
What Do You Need Before You Start?
Before you deposit, you need a wallet you control. On Ethereum, you also need ETH for gas. You must hold both tokens and select the correct network.
How Do You Provide Liquidity Step by Step?
To provide liquidity, you add both tokens to the pool contract. The contract records your share. Check each approval and confirmation before you sign.
- 1Check the pool contractConfirm the token pair, network, and contract address.
- 2Approve token spendingApprove only the amount you need, not unlimited spending.
- 3Add both tokensDeposit the pair in the ratio the pool requires.
- 4Receive LP tokensThe contract sends LP tokens that represent your share.
- 5Withdraw your shareBurn the tokens and confirm the withdrawal.
What Should You Do After Depositing?
After you deposit, your share can change in value. Impermanent loss happens when pool prices diverge from holding the tokens. The IRS treats crypto as property, so keep records of deposits, withdrawals, and fees.
- Your pool share over time
- Admin controls and upgrade keys
- Your transaction hash and date
- Any change in the pool token ratio
Frequently asked questions
Compare the fee share and the pool's price movement. Higher fees often come with higher price risk.
Usually no, beyond your deposit. A hack or a failing token can wipe out the pool.
Your pool share may have little value. Recovery is usually not possible.
Yes, on Ethereum a withdrawal is a transaction that needs gas. You also pay gas to approve and deposit.
