DeFi 101: Liquidity Pools Explained

One of the most innovative aspects of the cryptocurrency market is the ability to add liquidity in a permissionless way. Years ago, the automated maker maker (AMM) was a breakthrough. Still, it may be confusing to newcomers. How does it work, and how can you add your own liquidity?

The most popular AMM currently is Uniswap, whose model has been replicated by many other protocols. Today, protocols like Curve, 1inch, SushiSwap, Balancer, and others rely on the AMM model. Because it is the ‘gold standard’ for liquidity pools, it’s mainly what we’ll discuss here.

How Liquidity Pools Work

Liquidity pools are what make decentralized finance (DeFi) possible. Because of AMMs, there is no “matching” between the expected and executed prices. By automating the gap between buyers and sellers, DeFi has established something reenergized in finance.

This is all possible because of liquidity pools. Pools are constituted of any two tokens: let’s call them token A and token B. Generally speaking, pools are made up of half of A and half of B. However, there are some exceptions. Some pools offer other ratios of A and B tokens. Generally, though, 50:50 is what you should expect.

When a user provides liquidity, one has to initiate a transaction that provides both A and B tokens to the pool. In return, the user receives a token representing their pool share. The liquidity provider earns a trading fee each time a trade goes through the pool. Uniswap, for example, generally goes by a transaction fee of 0.3%.

Here is how this would work in practice for Uniswap v3:

1. Let’s say you want to provide liquidity to the ETH-USDC pool.
2. You would go to Uniswap and go to the “Pool” tab.
3. Choose your fee tier (generally 0.3%).
4. Set your price range. This is something new to v3, but generally, you can make it equal on both sides.
5. Deposit the amount required of ETH and USDC needed for your choice, usually 50–50 of each.
6. Approve the transaction, and you’re all done.

You can then track your earnings and pool deposits in the Uniswap dashboard.

Adding liquidity is, therefore, relatively straightforward. It is also one of the safest ways to earn sustainable yield in DeFI. Some of the most popular pools are stablecoins (USDC-USDT, for example) or ETH-stablecoin denominated. These are generally price stable while offering consistent fees for liquidity providers across time.

Let’s Talk about Impermanent Loss

You can’t discuss liquidity pools without bringing up impermanent loss (IL). IL is a persistent problem for liquidity providers.

Sometimes, it can happen that you would have been better off not providing liquidity at all. This is because pools take from one side to add to the other. If demand for token A is high, you will lose some of token B in the process. What this produces is what’s called impermanent loss. The increasing price of A will leave liquidity providers with more of B. They would have been better off if they had just held A, so it’s counted as a “loss.”

But in reality, IL is often a misnomer. LP tokens can often be staked for boosted returns, often offered by protocols to liquidity providers. This is meant to both incentivize liquidity and also offset any potential IL. Additionally, providing liquidity is still a safe, straightforward option because you consistently earn some profit regardless of where the price goes.

Because of IL, the best-case scenario for liquidity providers is sideways price action. This way, you earn fees while also not experiencing IL. In this case, boring is often better for your bottom line.

Are You Ready to be a Liquidity Provider?

As a liquidity provider, you are taking a fundamental step into DeFi. You are no longer just trading but creating a compostable money lego. And that lego can be used elsewhere. Deposit that LP token to earn further yield if possible. It can get complex very quickly.

But the good news is you can start small with the most significant pools. There’s little room for error when beginning with ETH-USDC or other pools. In time, you’ll realize that managing your own assets is easily doable as you earn a cut from the 24–7 market that is crypto.