What is a liquidity pool?

A liquidity pool is a pot of crypto, usually two different tokens, locked in a smart contract so that anyone can swap one token for the other. Pools replace the buyers and sellers that a traditional exchange brings together. They are the machinery behind most decentralized exchanges.

How does a liquidity pool work?

Take a pool holding ether and a dollar stablecoin. A trader who wants ether adds stablecoins to the pool and takes ether out. No other person has to be on the opposite side of the trade.

The price is set by a formula, not by a company. In the most common design, the formula keeps the two sides of the pool in balance. As ether leaves the pool and stablecoins arrive, ether becomes scarcer in the pool and its price there rises.

If the pool's price drifts away from the price elsewhere, traders step in to profit from the gap. Their buying and selling pulls the pool back in line with the wider market.

Who puts the money in?

The tokens come from liquidity providers. These are ordinary users who deposit both tokens, usually in equal value. In return, they get a receipt token that records their share of the pool.

Every swap pays a small fee, and the fee is shared among the providers. That is the incentive to supply funds. The catch is that a provider's mix of tokens changes as prices move, and they can end up worse off than if they had simply held the tokens. This is called impermanent loss.

Why do pools matter for meme coins?

A pool is how most new tokens first become tradable. The creator of a meme coin pairs a supply of the new token with an established coin, such as ether or SOL, and trading can begin within minutes. No exchange has to approve the listing.

Two things follow. First, a new pool is often small, so even a modest purchase moves the price a long way, in either direction. Second, whoever holds the pool's receipt tokens can withdraw the funds.

If a creator pulls the established coin out of the pool, holders are left with a token and nothing to sell it for. This is one common form of rug pull. Some projects lock or destroy their receipt tokens to show the pool cannot be withdrawn. That removes one risk but is not a guarantee of honesty.

What are the risks?

• Code bugs. A flaw in the pool's contract can let an attacker drain it.
• Thin pools. In a small pool, the price a trader gets can differ sharply from the price quoted, a gap known as slippage.
• Fake tokens. Anyone can create a pool for any token, including copies that borrow a well-known name.
• No recourse. There is no company to complain to if a pool is emptied.