A liquidity pool is a reserve of cryptocurrency tokens deposited into a smart contract on a blockchain. These pools are the engine behind decentralised exchanges, lending protocols and other DeFi applications. Instead of relying on a traditional order book to match buyers and sellers, a DEX uses liquidity pools and a mathematical formula to determine prices and execute trades.
How a liquidity pool works
Most DEX liquidity pools require two tokens in equal value. For example, an ETH/USDT pool on Uniswap might hold Rs 10 crore worth of Ethereum and Rs 10 crore worth of USDT. When a trader swaps ETH for USDT, they add ETH to the pool and remove USDT. The ratio changes, and the price adjusts accordingly.
The pricing formula commonly used is: **x * y = k**, where x and y are the quantities of each token and k is a constant. As one token is removed, the other must increase to keep k the same, which is what makes the price move.
Liquidity providers
Anyone can become a liquidity provider (LP) by depositing tokens into a pool. In return, they receive LP tokens representing their share of the pool. LPs earn a portion of the trading fees generated whenever someone trades against the pool. They can withdraw their share at any time by returning their LP tokens.
Earning from liquidity pools
| Income source | Description |
|---|---|
| Trading fees | A percentage of each trade, split among all LPs |
| Farming rewards | Additional tokens from yield farming incentives |
| Protocol incentives | Some protocols distribute governance tokens to LPs |
Impermanent loss
This is the primary risk for liquidity providers. When the price ratio of the two tokens changes significantly from when you deposited, the pool rebalances, and your holdings shift toward the token that has fallen in value. If you withdraw at this point, you end up with less value than if you had simply held the tokens. The loss is called impermanent because it reverses if prices return to the original ratio.
Liquidity pools and Indian tax
Depositing into and withdrawing from a liquidity pool may each constitute a taxable event under Indian VDA tax rules. Trading fees and farming rewards earned are treated as VDA income and taxed at 30% under Section 115BBH. The complexity of tracking every interaction makes record-keeping critical.
Risks
- Impermanent loss: the core risk for all LPs.
- Smart contract bugs: a vulnerability can drain the entire pool.
- Rug pulls: a malicious project can withdraw liquidity without warning.
- Low liquidity pools: smaller pools have higher slippage, making large trades expensive.