How Liquidity Pools Work
You've now swapped against a liquidity pool; this lesson explains the other side of that transaction — how the pool itself gets funded, and what it's like to be one of the users supplying it. Anyone can become a liquidity provider (LP) by depositing an equal value of both tokens in a pair into a pool — for example, depositing $500 of ETH and $500 of USDC into an ETH/USDC pool. In exchange, the protocol issues the depositor an LP token, which represents their proportional share of the entire pool.
Every time another user swaps against that pool — exactly as you did in the previous lessons — they pay a small trading fee, typically a fraction of a percent of the trade value, which is added directly into the pool's reserves rather than paid out separately. Because LP tokens represent a proportional share of the pool, and the pool's total value grows continuously as fees accumulate, an LP's share grows in value over time purely from trading activity, without the LP needing to do anything after their initial deposit. This is the core mechanism of "earning yield" from liquidity provision: you're being paid a share of every trade that uses the liquidity you supplied, proportional to how much of that liquidity is yours.
It's worth being precise about what you actually own as an LP: you don't own a fixed amount of each token — you own a percentage of the pool, and the pool's internal ratio between the two tokens shifts constantly as swaps happen. This detail, which seems minor here, is the direct cause of "impermanent loss," the subject of the very next lesson, so pay close attention to the wording: your value is tied to your share of the pool, not to a fixed quantity of each token you originally deposited.
Worked Example
Suppose a particular ETH/USDC pool holds a total of $1,000,000 in value (combining both token reserves). You deposit $500 of ETH and $500 of USDC — $1,000 total — making you the owner of 0.1% of the pool ($1,000 ÷ $1,000,000). From that point forward, every trading fee generated by anyone swapping through that pool is added to the pool's reserves, and your LP token entitles you to withdraw 0.1% of whatever the pool's total reserves are at the time you choose to withdraw — which, assuming trading activity continues and no major price divergence between ETH and USDC occurs, will be somewhat more than your original $1,000 purely from accumulated fees.
If the pool generates $2,000 in trading fees over a month from all users' swap activity, your 0.1% share entitles you to approximately $2 of that — not paid out separately, but reflected in the increased value your LP token can be redeemed for. Scaled up, if the pool consistently generates similar fee volume, you could roughly annualize this to estimate a rough fee-only yield, which is exactly what the next exercise asks you to calculate — though, as the very next lesson explains, this fee income is only part of the story once prices move.
It's worth also noting what the LP token itself actually is, mechanically, because it's the mechanism that makes all of this tradeable and composable with other DeFi protocols. The LP token is a standard, transferable token in its own right — you can hold it in your wallet, send it to someone else (effectively transferring your pool position to them), and in many protocols, even deposit that LP token into a second protocol to earn additional rewards on top of your trading fees, a pattern often called "yield stacking" or using the LP token as collateral elsewhere. This composability is part of what the course's summary meant by "money legos" in Module 1: your liquidity position isn't a dead end, it's itself a building block other protocols can plug into.
Common Pitfalls
- Depositing into a pool without checking its TVL and trading volume history first. A pool with high advertised APR but very low volume or recently crashed TVL is a red flag worth investigating before depositing, not after.
- Forgetting that your LP token's underlying token quantities change, even though you deposited a specific amount of each. This is the direct setup for impermanent loss, covered next — don't assume you can withdraw the exact quantities you deposited.
- Not checking withdrawal mechanics before depositing. Some protocols impose a brief lock-up or withdrawal queue during high-utilization periods; know this before you commit funds you might need quickly.
Exercise
Find a real ETH/USDC pool (or a comparable major pair) on a DEX interface, or use cached data if live access isn't available, and note two numbers: its total value locked (TVL) and its trading volume or fee revenue over the past 24 hours. Calculate what a hypothetical $1,000 deposit's proportional share of that pool would be (your $1,000 ÷ the pool's TVL), then apply that share to the 24-hour fee figure to estimate your daily fee income, and roughly annualize it (multiply by 365) to get a rough fee-only yield estimate.
Keep this number — label it clearly as "fee-only yield, before impermanent loss," because the next lesson introduces the other side of the ledger that this estimate is currently ignoring, and the lesson after that teaches you how to compare the two directly.
Recap
- Liquidity providers deposit equal value of two tokens into a pool and receive an LP token representing a proportional, not fixed, share of the pool.
- Trading fees from every swap accrue into the pool, growing an LP's share in value over time without further action required.
- Your calculated fee-only yield is incomplete until you account for impermanent loss, covered in the very next lesson.