What Is a Liquidity Pool and How to Use It

In the DeFi world, there’s a concept that quietly powers nearly everything—from token swaps to yield farming. It’s called a liquidity pool. If you’ve ever traded or swapped on a decentralized exchange (DEX) or earned passive income from DeFi, you’ve already used one—maybe without even knowing it.

But what exactly is a liquidity pool? How does it work? And how can you use one to earn rewards?

Let’s look in the details.

What Is a Liquidity Pool?

At its core, a liquidity pool refers to a collection of funds—usually two different cryptocurrencies—locked inside a smart contract. These funds are used to enable decentralized trading without any third-party as intermediary, like a traditional broker or centralized exchange.

Instead of relying on buyers and sellers to match orders just like in traditional methods of finance, decentralized exchanges use liquidity pools. Users, known as liquidity providers, contribute equal values of any two tokens to a pool—say, 1 ETH and $3,000 USDT. In return, most platforms offer them a share in the trading fees generated by other users swapping those tokens.

In short:

• Liquidity pools enable decentralized token swaps.
• Users supply crypto assets and earn rewards.
• These Pools are the backbone of most of the DeFi platforms.

Why Do Liquidity Pools Matter?

Picture trying to trade a token on a DEX, only to discover no one is available to take the other side of your trade. That’s where liquidity pools come in—they guarantee there’s always liquidity available, meaning you can swap anytime, without the need of any intermediary party.

This setup has completely changed how we trade in DeFi. It:

• Ensures 24/7 access to token swaps.
• Creates opportunities for token holders to make passive income.
• Supports DeFi applications like lending, yield farming, and borrowing.

Without liquidity pools, most of DeFi simply wouldn’t work.

How Do Liquidity Pools Work?

Let’s say you want to provide liquidity to an ETH/USDT pool.

You’d deposit both ETH and USDT in a 50:50 ratio. That might be 1 ETH and 3,000 USDT, assuming ETH is priced at $3,000. These tokens enter the smart contract that anyone can trade against.

Each token price in the pool is governed by a simple algorithm known as the constant product formula, which is as follows:

x * y = k

Here:

• x = amount of Token A (ETH),
• y = amount of Token B (USDT),
• k = constant product (stays the same during swaps).

This formula confirms that after every trade, the balance between the two tokens adjusts automatically while maintaining the same product (k). The bigger the pool, the less price impact of the single trade—this is called low slippage.

What Do Liquidity Providers Get in Return?

When you add funds to any liquidity pool, you become a liquidity provider. In return for supplying your tokens, you receive LP tokens—a kind of digital receipt that represents your share in the pool.

These LP tokens entitle you to:

• A portion of the trading-fees (usually 0.3% per swap, divided among LPs).
• Incentives like platform rewards or governance tokens.
• The ability to stake or farm your LP tokens for extra yield (on some platforms).

Once you’re done, you can burn your LP tokens and get your original crypto back—plus any earnings.

But there’s a catch...

Impermanent Loss Risk

Providing liquidity isn’t completely risk-free. The biggest risk is something called impermanent loss.

Here’s the short version: If the price of the tokens you deposited changes significantly compared to when you deposited them, you might end up with less value when you withdraw, compared to just holding the tokens.

Why? Because as prices change, the pool automatically rebalances, which means you may withdraw more of one token and less of the other. The “loss” is only in comparison to holding your tokens—it’s impermanent because it might even out if the prices return to their original level.

However, trading fees and associated rewards can often offset this risk—especially if the crypto liquidity pool has high volume.

How to Use a Liquidity Pool (Step-by-Step with ARMswap)

Now that you understand what liquidity pools mean and how they work, let’s look at how to actually use one. We’ll use ARMswap, a cross-chain DEX designed for easy and safe token swaps across multiple different blockchain networks.

Step 1: Connect Your Crypto Wallet

Head to the ARMswap platform and connect your Web3 wallet—like MetaMask.

Please make sure your wallet holds the tokens you want to deposit and that you’re on the correct network like Arbitrum or BNB Chain, etc.

Step 2: Select a Pool

Reach to the “Liquidity” section and choose a token pair you’d like to provide. ARMswap offers a variety of decentralized liquidity pools like:

• ETH/BNB
• POL/ARB

Select one that matches your risk appetite and tokens you already hold.

Step 3: Add Liquidity

Enter the amount of both tokens you wish to add in the pool. Approve both tokens and then confirm the liquidity deposit.

Once confirmed, you’ll receive ARMswap LP tokens in the connected wallet. They represent your share of the pool.

Step 4: Earn Rewards

Now, just sit back and earn! Every time someone performs a swap in the pool you contributed to, you get a cut of the trading fees of platform.

Step 5: Withdraw When Ready

Whenever you want to exit, head back to the liquidity section, remove your share, and receive your original tokens—plus any earnings. Keep an eye on impermanent loss risk and monitor the pool's performance from your dashboard.

Best Practices for Using Liquidity Pools

If you are still wondering about how to invest in liquidity pools, continue reading the following steps.

1. Start small: If you're new, test it out with a small deposit first. Understand the mechanics before committing large amounts.
2. Pick stable pairs: Pairs like USDT/USDC or ETH/stETH tend to have lower impermanent loss.
3. Diversify: Don’t put all your crypto in one pool. Spread it out to balance your risk.
4. Watch gas-fees: On some expensive blockchains e.g Ethereum, transaction fees mostly eat up the earned profits. ARMswap supports multiple chains to help with this.
5. Know the platform: Fee structure varies on different DEXs, incentives, and risks. ARMswap is designed for cross-chain functionality and user-friendly liquidity tools.

Final Thoughts

Liquidity pools can be named as the unsung heroes of DeFi. They allow anyone—from casual holders to experienced investors—to generate side income by supporting decentralized markets.

By contributing to a pool, you’re not only earning rewards—you’re also powering the DeFi revolution. And with platforms like ARMswap making it easy and accessible, it might be a best time to enter this side of crypto.

Please note that every opportunity has associated risks, and providing liquidity is no different. Do your homework, start small, and you’ll eventually be earning like a pro—even while you sleep.