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What is a liquidity pool?

A liquidity pool is a collection of funds locked in a smart contract. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. You could think of a liquidity pool as a big pile of funds that traders can trade against. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool.

The risks of liquidity pools

If you provide liquidity to an AMM, you’ll need to be aware of a concept called impermanent loss. If you’re providing liquidity to an AMM, you’re probably exposed to impermanent loss. Make sure you clearly understand how impermanent loss works if you’re considering putting funds into a liquidity pool.

Another thing to keep in mind is smart contract risks. When you deposit funds into a liquidity pool, they are in the pool. So, while there are technically no middlemen holding your funds, the contract itself can be thought of as the custodian of those funds. If there is a bug or some kind of exploit your funds could be lost forever.