What is a liquidity pool?
A liquidity pool is a collection of tokens locked in a smart contract that powers decentralised exchanges (DEXs). Instead of matching buyers with sellers (like a traditional order book), DEXs use liquidity pools to execute trades automatically using mathematical formulas.
How liquidity pools generate yield
When traders swap tokens on a DEX, they pay a small fee (typically 0.01%–1%). This fee is distributed proportionally to all liquidity providers (LPs) in the pool. The more trading volume a pool sees, the more fees LPs earn.
Concentrated liquidity (PancakeSwap V3)
PancakeSwap V3 introduced concentrated liquidity — LPs can specify a price range where their capital is active. This dramatically increases capital efficiency: instead of spreading liquidity across all possible prices, you concentrate it where most trading happens, earning more fees per dollar deployed.
Impermanent loss
The main risk of providing liquidity is impermanent loss — if the price ratio of the two tokens changes significantly, you end up with less value than if you'd simply held the tokens. This is why stablecoin-to-stablecoin pools (USDT/USDC) are lower risk: the price ratio barely changes.
USDT/USDC pools
Pools containing two stablecoins (like USDT/USDC) have minimal impermanent loss because both tokens maintain approximately the same value. They earn yield purely from trading fees — high volume, low risk.