How to earn on liquidity pools: a complete breakdown of DeFi mechanics

Summary

• Crypto-asset flows in smart contracts are the foundation of decentralized trading, allowing traders to operate without intermediaries.
• Instead of traditional market makers, the system operates through automated pricing algorithms, where each participant trades directly with the pool.
• Those who provide funds ( suppliers ) receive commissions and bonuses, but must take into account hidden losses and technical risks.
• Innovative schemes (, for example, high-yield farming ), open up additional earning opportunities.

How it all begins: the role of liquidity pools in decentralized finance

Decentralized finance has radically changed the approach to trading assets and generating income. Instead of centralized platforms, there is now a network of independent protocols where users interact directly. At the heart of this revolution are the reserve pools of assets.

It is precisely these that allowed the emergence of the DEX platform ecosystem and dozens of fintech projects on top of them. If you are new to DeFi or want to delve deeper into the mechanics, this breakdown is for you.

Essence: what lies behind the term “reserve pool”

The reserve pool is a collection of cryptocurrencies or digital tokens that are coded into a smart contract. They provide liquidity for asset exchanges, lending, and other financial operations within the protocol.

The main difference from the old system is that there is neither an order book nor a central market maker. Instead, DeFi applications use a mechanism of automatic price calculations ( known as AMMs) along with asset pools to facilitate instant swaps.

Thanks to this approach, the need for a long search for a counterparty is eliminated. Anyone can make an exchange using the funds in the pool, and the value of each token is automatically recalculated based on the current asset ratio.

How this system works in practice

Liquidity providers: who they are and what they do

People who contribute their funds to the pool are called liquidity providers or LPs. They typically deposit two different currencies simultaneously of equal value — for example, ether and a stablecoin.

In exchange, the system issues them special “tickets” ( LP tokens ), confirming their share in the overall reserve. Every time someone makes a transaction in the pool, the fee ( usually ranges from 0.01% to 1% ) and is distributed among all providers in proportion to their shares.

This creates a source of passive income. Moreover, these LP tickets can be used in other protocols to earn additional rewards. This process is called yield farming or liquidity mining.

( Automatic cost calculators )AMM###: how the price is determined

AMM is an algorithm in the code that calculates the fair price of tokens in a pool. The most common formula looks like this: