Liquidity Pools in Plain English: LP Tokens, Fees, and Impermanent Loss

What Is a Liquidity Pool?

A liquidity pool is a smart contract that holds reserves of two tokens (like ETH and USDC). Traders swap against these reserves instead of finding a counterparty. You provide the liquidity by depositing tokens, and you earn fees from trades.

Think of it like a vending machine: you stock it with products (tokens), customers buy from it (trades), and you earn a small fee on each sale. The machine automatically adjusts prices based on supply and demand.

How Liquidity Pools Work

The Constant Product Formula

Most pools (Uniswap V2 style) use: x * y = k

This means the amount of token X times the amount of token Y always equals a constant. When someone trades, the pool adjusts to maintain this constant, which determines the price.

Example: Pool has 1,000 ETH and 2,500,000 USDC. Someone swaps 1 ETH for USDC. Pool calculates how much USDC to give to maintain x * y = k. Price adjusts automatically.

Providing Liquidity

To provide liquidity, you deposit equal values of two tokens:

• Example: Deposit 1 ETH ($2,500) and 2,500 USDC
• You must deposit equal dollar values (50/50 split)
• Pool calculates your share based on what you deposit
• You receive LP tokens representing your share

Why 50/50? The pool needs both tokens for trading. If you only deposit ETH, traders can't swap ETH for USDC (no USDC in pool).

LP Tokens: Your Receipt

When you provide liquidity, you receive LP (Liquidity Provider) tokens. These represent your share of the pool.

What LP Tokens Are

LP tokens are like a receipt or share certificate:

• They prove you own a share of the pool
• The amount you get represents your percentage ownership
• You need them to withdraw your liquidity later
• They can be transferred, traded, or used in other protocols

How LP Tokens Work

When you deposit: You get LP tokens proportional to your share. If you deposit 1% of the pool's value, you get 1% of LP tokens.

LP tokens increase in value: As fees accumulate, your share of the pool grows. When you withdraw, you get more tokens than you deposited (from fees), but LP token count stays the same - each token is worth more.

When you withdraw: Burn LP tokens to get your share back (your original tokens plus accumulated fees, minus any impermanent loss).

Using LP Tokens

LP tokens can be:

• Staked in yield farms for additional rewards
• Used as collateral in lending protocols (some accept LP tokens)
• Traded (though liquidity is usually low)
• Held to earn fees (no staking needed - fees accrue automatically)

How Fees Work

You earn fees from every trade that happens in your pool. Here's how:

Fee Structure

When someone trades, they pay a fee (usually 0.05-1%):

• Fee goes to the pool (not the protocol)
• Your share of fees = your share of the pool
• Fees accumulate in the pool (increase pool value)
• When you withdraw, you get your share of accumulated fees

Calculating Your Fees

Example: Pool has $1M total value, you own 1% ($10k). Someone trades $10k and pays 0.3% fee ($30). Your share: $0.30. Small, but adds up with volume.

Annual yield: If pool does $100M volume per year at 0.3% fee = $300k fees. Your 1% share = $3k/year = 30% APY (on your $10k). But this depends on volume staying high.

What Affects Fees

• Volume: More trading = more fees
• Fee tier: Higher fee pools earn more per trade
• Your share: Larger share = more fees
• Pool size: Smaller pools = larger share = more fees per dollar (but higher risk)

Impermanent Loss: The Reality

Impermanent loss is the biggest risk of providing liquidity. Here's what it means:

What Is Impermanent Loss?

Impermanent loss happens when token prices change relative to each other. You end up with less value than if you'd just held the tokens.

Why it happens: The pool maintains 50/50 value ratio. If ETH price doubles, the pool automatically rebalances - you end up with less ETH and more USDC. You'd have made more just holding ETH.

Example of Impermanent Loss

You deposit 1 ETH ($2,500) and 2,500 USDC into a pool. Total: $5,000.

ETH price doubles to $5,000. If you'd just held:

• 1 ETH = $5,000
• 2,500 USDC = $2,500
• Total: $7,500 (50% gain)

But in the pool (maintaining 50/50 ratio):

• You'd have ~0.707 ETH (~$3,535)
• And ~3,535 USDC
• Total: ~$7,070 (41% gain)

Impermanent loss: $430 (you made less than holding). This is "impermanent" because if prices return to original, loss disappears. But if you withdraw now, it becomes permanent.

When Impermanent Loss Is Worst

IL is worst when:

• Prices diverge significantly (one goes up, one stays same)
• High volatility pairs (ETH/BTC worse than USDC/USDT)
• You withdraw when prices are different from deposit

Stablecoin pairs: USDC/USDT has minimal IL (prices stay similar). This is why many LPs prefer stablecoin pairs.

Can Fees Cover Impermanent Loss?

Sometimes. If fees are high enough and volume is consistent, fees can exceed IL. But this isn't guaranteed. Many LPs lose money overall due to IL exceeding fees.

Rule of thumb: Fees need to be 20-50%+ APY to cover typical IL in volatile pairs. Stablecoin pairs need less (5-10% APY often covers IL).

Risks of Providing Liquidity

1. Impermanent Loss

Biggest risk. Can exceed fees, especially in volatile pairs.

2. Smart Contract Risk

Pools can be hacked, have bugs, or fail. Use well-audited protocols.

3. Token Risk

If one token goes to zero, you lose everything (pool becomes worthless).

4. Low Volume

Low trading volume = low fees. Might not cover IL or gas costs.

5. Rug Pulls

Malicious tokens can drain pools. Only provide liquidity for legitimate tokens.

Best Practices

1. Start with Stablecoin Pairs

Lower IL risk. USDC/USDT, DAI/USDC are safer for beginners.

2. Use Established Protocols

Uniswap, Curve, Balancer are battle-tested. Avoid new protocols without audits.

3. Understand IL Before Providing

Use calculators to estimate IL. Don't provide liquidity if you can't handle the risk.

4. Monitor Your Position

Check regularly. IL can accumulate. Withdraw if it exceeds fees.

5. Consider Fee Tiers

Higher fee tiers (1% vs 0.05%) earn more but might have less volume. Research which works better for your pair.

Final Thoughts

Providing liquidity can be profitable, but it's not free money. Impermanent loss is real, and fees don't always cover it. Understand the risks before depositing.

Start with stablecoin pairs, use established protocols, and don't invest more than you can afford to lose. LP tokens are useful, fees can be good, but IL can eat your profits.

The key is understanding what you're getting into. Liquidity provision is a trade-off: you earn fees but face IL. Make sure fees exceed IL, or you'll lose money. Do your research, start small, and learn as you go.