Liquidity pools & impermanent loss
Decentralized exchanges don't use an order book, they use pools of two assets that anyone can trade against. Provide to a pool and you earn a cut of every trade. There's a catch, and it has a name.
How an AMM pool works
You deposit a pair (say ETH + USDC) into a pool. Traders swap against it, and a formula keeps the pool balanced by adjusting the price. Every swap pays a fee, split among liquidity providers in proportion to their share. Your deposit is represented by an LP token you can later redeem.
Impermanent loss, plainly
When the two assets' prices diverge, the pool's rebalancing leaves you with more of the loser and less of the winner than if you'd just held. That gap versus simply holding is impermanent loss, "impermanent" because it shrinks if prices return, and becomes real when you withdraw.
Sizing the trade-off before you deposit
Providing liquidity is a bet that fees earned beat impermanent loss over your holding period. Both sides are estimable in advance from public pool data.
| Variable | Where to read it | What it tells you |
|---|---|---|
| Fee APR = (24h volume × fee tier × 365) ÷ TVL | Pool page: volume, fee tier, TVL | Your gross income rate. Falls as TVL grows |
| Volume ÷ TVL ratio | Same two figures | Below ~0.3 daily, fees rarely cover IL |
| Pair correlation | Price history of both assets | Stable–stable, near-zero IL. Volatile–stable, worst case |
| Expected price divergence | Your own view on the pair | Sets the IL you are accepting, see figures below |
| Share of rewards paid in the protocol token | Pool rewards breakdown | Emission-funded APR can collapse; fee APR is the durable part |
Impermanent loss on a standard 50/50 pool is a fixed function of the price ratio change, so you can price it up front: a 1.25× move costs about 0.6% versus holding, 1.5× costs about 2.0%, 2× costs about 5.7%, 4× costs about 20%. Compare that against the fee APR you computed for the same period. If you expect one asset to run hard, holding it outright usually wins.
Before you provide
- Prefer correlated or stable pairs to limit IL (e.g. two stablecoins).
- Check pool volume, fees only add up with real trading.
- Audit the contract; pools are a common exploit target.
Educational market information, not financial advice. Markets carry risk of loss, do your own research.