Liquidity Pools Explained: AMM Basics

Automated Market Makers (AMMs) revolutionized decentralized exchanges by replacing order books with algorithmic pricing. Understanding how they function helps evaluate providing liquidity versus trading.

Traditional Order Books vs AMMs

Centralized exchanges use order books matching buyers and sellers at specified prices. This requires sufficient participants at various price levels to maintain liquidity. Market makers actively update orders to provide continuous pricing.

AMMs eliminate order books entirely. Instead, liquidity pools hold token pairs. Algorithms determine prices based on pool ratios. Anyone can trade against pools; anyone can provide liquidity.

The shift from active market makers to passive liquidity pools democratized market making. Previously, only specialized firms with sophisticated algorithms could provide liquidity profitably. AMMs enable anyone to earn trading fees by depositing assets.

Constant Product Formula

Most AMMs use the constant product formula: x * y = k, where x and y are token quantities and k remains constant. When someone trades, they add one token and remove another, maintaining the product.

This simple equation creates an automated market maker. As pool ratio changes, prices adjust automatically. Large trades relative to pool size face worse rates (slippage).

For example, a pool with 100 ETH and 200,000 USDC has k = 20,000,000. If you buy 10 ETH, you add USDC and remove ETH such that the product remains constant. The price you pay increases as the pool ratio shifts, creating slippage.

This formula creates an infinite liquidity curve. Pools never fully empty - they just become increasingly expensive. Buying the last token would require infinite capital.

Providing Liquidity

Liquidity providers deposit equal values of both tokens. They receive LP tokens representing their pool share. Trading fees accumulate in the pool, increasing LP token value.

Providers can withdraw by burning LP tokens, receiving proportional amounts of both pool tokens. The ratio may differ from deposit due to trading activity.

If you deposit $1000 worth of ETH and $1000 worth of USDC into a pool with total liquidity of $100,000, you receive 2% of LP tokens. When you withdraw, you get 2% of whatever tokens the pool contains, which may be different quantities than you deposited.

Impermanent Loss

Impermanent loss occurs when token price ratios change after depositing. If you held tokens separately instead of providing liquidity, you might have more value at current prices.

The loss is "impermanent" because it only materializes upon withdrawal. If ratios return to initial levels, the loss disappears. However, for trending assets, the loss often becomes permanent.

Calculation shows that 2x price change causes ~5.7% loss, 5x causes ~25% loss. Trading fees must exceed this to profit. High-volume pools with stable ratios work best.

Impermanent loss is often misunderstood. You're not losing money in absolute terms - you're missing gains relative to holding. If ETH doubles against USDC, liquidity providers profit, just less than if they'd held ETH alone.

The mathematical relationship is: IL = (2 * sqrt(price_ratio)) / (1 + price_ratio) - 1. This non-linear function means small price changes cause minimal loss, but large divergences significantly impact returns.

Fee Structures

AMMs charge trading fees, typically 0.3% per swap. These accumulate in pools, distributed proportionally to liquidity providers when they withdraw.

Some protocols implement tiered fees based on volatility or allow governance to adjust rates. Concentrated liquidity models enable custom fee tiers for different risk profiles.

Uniswap V3 offers 0.05%, 0.3%, and 1% fee tiers. Stablecoin pairs typically use 0.05% due to low volatility. Exotic pairs might use 1% to compensate for higher impermanent loss risk.

Fees compound automatically as they're reinvested into the pool. Your LP tokens represent a growing share of total pool value, assuming trading volume generates sufficient fees.

Pool Selection

Not all pools are equal. Factors to consider:

Volume generates fees but indicates volatility. High-volume pools pay more fees but experience more price movement, increasing impermanent loss.

Deeper liquidity means less impermanent loss impact. Your deposit forms a smaller percentage of total pool, so individual trades affect you less.

Correlated assets (stablecoin pairs) minimize IL. USDC/DAI pools face minimal price divergence, making fees nearly pure profit.

Token quality affects rug pull risks. Providing liquidity to unknown tokens exposes you to total loss if developers abandon or exploit the project.

Additional incentives may be offered. Protocols often incentivize specific pools with governance token rewards, potentially exceeding trading fees.

Concentrated Liquidity

Uniswap V3 introduced concentrated liquidity, allowing providers to specify price ranges. Capital efficiency improves dramatically - the same liquidity serves more trading in the chosen range.

However, if prices move outside your range, you stop earning fees and may face increased impermanent loss. Active management becomes necessary for optimal returns.

Concentrated liquidity suits sophisticated providers willing to actively manage positions. Passive providers often prefer full-range liquidity despite lower capital efficiency.

Narrow ranges amplify both fees and impermanent loss. A position concentrated near current price earns maximum fees but quickly falls out of range during volatility.

Single-Sided Liquidity

Some protocols enable single-sided liquidity provision. You deposit only one token, and the protocol manages pairing. This simplifies provision but often introduces additional risks through protocol-issued tokens or complex mechanisms.

Bancor pioneered impermanent loss protection, gradually eliminating IL over time in positions held beyond 100 days. This protection came from protocol token inflation, essentially socializing losses.

Risks

Smart contract risks affect all DeFi. Bugs or exploits could drain pools. Major protocols undergo audits, but risks remain. The larger the pool, the bigger the target for hackers.

Token risks include rug pulls where developers drain liquidity. Verify token contracts and developer reputations before providing liquidity. Anonymous teams launching tokens warrant extreme caution.

Market risks include impermanent loss exceeding fee income, especially in trending markets. If you provide liquidity to ETH/USDC and ETH rallies 3x, impermanent loss will likely exceed fees earned.

Divergence loss represents the opportunity cost of providing liquidity versus holding. In bull markets for one asset, holding often outperforms providing liquidity.

Returns Calculation

Estimate returns by examining historical pool data. Metrics include:

Daily volume relative to liquidity (indicates fee generation) Historical impermanent loss patterns Additional incentive programs Gas costs for entering and exiting positions

APR calculators exist but rely on current conditions persisting. Actual returns vary significantly with market conditions.

Practical Strategies

Successful liquidity provision requires strategy:

Stablecoin pairs minimize impermanent loss. USDC/USDT or DAI/USDC pools offer steady returns with minimal IL.

Balanced exposure pairs (ETH/BTC) reduce directional risk. If you're bullish on both assets, IL becomes less concerning.

Concentrated ranges during sideways markets maximize fees. When assets trade in tight ranges, narrow positions excel.

Full-range passive positions suit set-and-forget approaches. Accept lower fees in exchange for reduced management.

Conclusion

AMMs democratize market making but introduce unique risks. Understanding impermanent loss and selecting appropriate pools helps manage these risks while potentially earning returns from trading fees. The key is matching strategy to market conditions and personal risk tolerance. Stablecoin pairs suit conservative providers, while volatile pairs attract those comfortable with impermanent loss in exchange for higher fee potential. Like all DeFi activities, start small and scale up as you gain practical understanding of how these systems behave across different market conditions.