Liquidity Pool

#Definition

A liquidity pool is a collection of tokens locked in a smart contract that enables trading without traditional buyer-seller matching. In prediction markets, liquidity pools hold outcome tokens (Yes and No) plus collateral (typically USDC), allowing traders to swap between them instantly at algorithmically determined prices.

Liquidity pools power automated market makers (AMMs) like those used on Polymarket. Instead of waiting for someone to take the other side of your trade, you trade against the pool itself. The pool is always willing to buy or sell at a price determined by its bonding curve.

#Why It Matters in Prediction Markets

Liquidity pools solve critical problems for prediction markets:

Continuous trading

Traditional markets require matching buyers and sellers; if no one wants to sell, you can't buy. Pools provide guaranteed liquidity, enabling trades 24/7 regardless of whether other humans are active.

Niche market viability

Prediction markets often cover obscure topics with few natural traders. Pools make these markets functional by ensuring basic liquidity from the start.

Permissionless market creation

Anyone can create a prediction market by depositing initial liquidity into a pool. This enables rapid market creation for emerging topics without waiting for market makers.

Transparent pricing

Pool mechanics are deterministic and public. Anyone can calculate exactly what price they'll pay for any trade size before executing.

#How It Works

#Pool Structure

A basic prediction market liquidity pool contains:

Pool Contents:
- Yes tokens: 10,000
- No tokens: 10,000
- Implied Yes probability: 10,000 / (10,000 + 10,000) = 50%

#Constant Product Formula

Most prediction market pools use the constant product formula:

Yes_tokens × No_tokens = k (constant)

When you buy Yes tokens, you add collateral and remove Yes tokens. The formula ensures the product stays constant, which automatically adjusts prices.

#Liquidity Pool Mechanics

#Trading Example

Starting state:

• Yes tokens: 10,000
• No tokens: 10,000
• k = 100,000,000

Trader buys 500 Yes tokens:

1. Calculate new Yes balance: 10,000 - 500 = 9,500
2. Calculate required No balance: 100,000,000 / 9,500 = 10,526.3
3. Trader must add: 10,526.3 - 10,000 = 526.3 No tokens (or equivalent USDC)
4. Effective price: 526.3 / 500 = $1.053 per Yes token

New state:

• Yes tokens: 9,500
• No tokens: 10,526.3
• k = 100,000,000 (unchanged)
• New Yes probability: 9,500 / (9,500 + 10,526.3) = 47.4%

The purchase moved the price because removing Yes tokens made them scarcer.

#Liquidity Provision

Anyone can become a liquidity provider (LP):

1. Deposit: LP adds 1,000 Yes + 1,000 No tokens
2. LP Tokens: Receives LP tokens representing pool share
3. Earning: Collects proportional share of trading fees
4. Withdrawal: Burns LP tokens to reclaim pool share

#Numerical Example: LP Returns

Pool state: 10,000 Yes, 10,000 No, $5,000 total value

LP deposits: $500 (5% of pool)

Over one month:

• Trading volume: $50,000
• Fee rate: 1%
• Fees collected: $500
• LP's share: $500 × 5$25

LP's return: $25 on$500 = 5% monthly

However, this ignores impermanent loss, which can exceed fee earnings in prediction markets.

#Examples

#Example 1: New Market Bootstrap

A user wants a market on whether a tech company will launch a product:

1. Creates market, deposits $2,000 initial liquidity
2. Pool initializes with equal Yes/No reserves
3. Price starts at $0.50 (50% implied probability)
4. Trading begins immediately; no need to recruit market makers

#Example 2: High-Volume Pool

A presidential election market has a large pool:

• Yes tokens: 500,000
• No tokens: 500,000
• Total value: ~$500,000

With this depth, a $10,000 trade moves the price minimally:

• Before: 50.00%
• After: 50.99%
• Slippage: ~1%

#Example 3: Thin Pool Volatility

A niche market has a small pool:

• Yes tokens: 1,000
• No tokens: 1,000
• Total value: ~$1,000

A $500 trade has massive impact:

• Before: 50.00%
• After: 72.36%
• Slippage: ~22%

#Example 4: Resolution Impact on LPs

An LP provides liquidity to an election market:

Before resolution: Pool has 6,000 Yes + 4,000 No (60% Yes probability)

Market resolves Yes:

• Yes tokens worth $1 each: 6,000 ×$1 = $6,000
• No tokens worth $0 each: 4,000 ×$0 = $0
• Pool value: $6,000

LP held: 10% of pool LP receives: $600

Had LP held tokens directly (bought at 50/50 and held):

• Would have had 500 Yes + 500 No
• Resolution value: 500 × $1 + 500 ×$0 = $500

The LP actually did better in this case, but outcomes can go either way.

#Risks, Pitfalls, and Misunderstandings

Impermanent loss (IL)

When prices move significantly, LPs suffer impermanent loss. In prediction markets, this is severe and permanent because outcomes resolve to $0 or$1.

Example:
- LP deposits at 50/50
- Price moves to 90/10
- LP withdraws and has more No tokens, fewer Yes tokens
- If Yes wins, LP has much less than they would have by just holding Yes

Example Calculation:

• You deposit $100 when odds are 50/50.
• Odds shift to 90/10.
• Your pool share is now worth ~$75 (due to rebalancing into the cheaper "No" tokens).
• If you had just held your initial tokens, they would be worth ~$90.
• Impermanent Loss: $15.

Resolution loss

At resolution, the pool necessarily holds losing tokens worth $0. LPs receive their share of whatever the pool contains, which always includes the losing side.

Low fee capture

Prediction markets often have lower fees than DeFi trading pairs. Combined with resolution loss, LP economics can be challenging.

Slippage for large trades

The smaller the pool relative to your trade, the worse your execution. Large traders in small pools face significant slippage.

Smart contract risk

Pools are smart contracts. Bugs, exploits, or vulnerabilities can result in lost funds. Use audited, established protocols.

#Practical Tips for Traders

• Check pool size before trading: Look for pools with depth significantly exceeding your trade size to minimize slippage

• Calculate slippage in advance: Use the constant product formula to determine your actual cost before executing

• Compare pool vs. order book execution: Some markets have both. Test which offers better prices for your size

• Don't LP in volatile markets naively: Prediction market LP is not passive income. Understand impermanent loss and resolution risk before providing liquidity

• Time entries for pool depth: Pools are often deeper during high-activity periods. Avoid trading during thin hours

• Watch for manipulation risk: Small pools can be manipulated with modest capital. Be skeptical of prices in thin pools

#Risks for Liquidity Providers: Impermanent Loss

The biggest risk for LPs is Impermanent Loss (or specifically in prediction markets, LVR - Loss Versus Rebalancing).

If the true probability of an event changes significantly (e.g., from 50% to 90%), the LP's pool will be "picked off" by informed traders. The LP ends up selling all their winning shares cheap and holding all the losing shares. This loss can exceed the fees earned.

#Related Terms

• AMM (Automated Market Maker)
• Bonding Curve
• Liquidity
• Slippage
• Polymarket

#FAQ

#Who provides liquidity to prediction market pools?

Various sources: the market creator (initial liquidity), professional LPs seeking fee income, platform incentive programs, and traders who want to earn on dormant capital. Unlike DeFi pools, prediction market LPs face resolution loss, limiting professional participation.

#How do I know if a pool is big enough?

Calculate the slippage for your intended trade using the constant product formula. If slippage exceeds 1-2%, consider breaking your trade into smaller pieces or waiting for more liquidity. Check the pool's total value relative to your position size.

#Can liquidity pools run out?

Technically no; the bonding curve makes the last tokens infinitely expensive, so the pool can never be fully drained. Practically, a pool can become so shallow that slippage makes trading uneconomic. This is "effectively illiquid."

#What fees do prediction market pools charge?

Typically 0.1% to 2% per trade. Lower than many DeFi pools but meaningful for frequent traders. Fees go to LPs as compensation for capital and risk.

#Is providing liquidity profitable?

It depends on trading volume, fee rates, price volatility, and final resolution. High-volume pools with moderate price movement can be profitable. Markets that resolve far from initial prices usually cause LP losses exceeding fee income. Model your expected return before depositing.