Liquidity Pools Explained

Advanced 19 minutes

Liquidity pools power $6.7B in Uniswap trades and $4.2B in Curve stablecoin swaps (January 2026). LPs earn 0.05-1% per trade, but impermanent loss can exceed fee income if prices diverge significantly.

What is a Liquidity Pool?

A liquidity pool is:

A smart contract holding two (or more) tokens
Anyone can trade against the pool
Prices determined by mathematical formula
Liquidity providers (LPs) earn fees from trades

How AMMs Work

Automated Market Makers (AMMs) use the constant product formula:

x * y = k (where k stays constant)
As you buy token A, its price increases
As you sell token A, its price decreases
No order books, no matching buyers/sellers

Example

Pool has 10 ETH and 30,000 USDC (k = 300,000). To buy 1 ETH, you need to add enough USDC to maintain k. The more you buy, the higher the price.

Providing Liquidity

How to Add Liquidity

Choose a pool (e.g., ETH/USDC)
Deposit equal value of both tokens
Receive LP tokens representing your share
LP tokens earn portion of trading fees

Earning Fees

Standard fee: 0.3% per trade (Uniswap v2)
Fees distributed proportionally to LPs
High volume pools = more fees
Fees compound automatically into position

LP Token Mathematics & Real Earnings

Pool Details	Your Share	Daily Volume	Daily Earnings	Annual APY
$10k in $1M pool (1%) 0.3% fee tier	1%	$500k	$15 (1% of $1,500)	54.8%
$10k in $1M pool (1%) 0.3% fee tier	1%	$100k	$3 (1% of $300)	10.9%
$10k in $100k pool (10%) 0.3% fee tier	10%	$50k	$15 (10% of $150)	54.8%

Fee Tiers Explained (Uniswap v3)

0.01%: Stablecoin pairs (USDC/USDT) - high volume, tiny spreads
0.05%: Similar assets (ETH/stETH) - most efficient
0.3%: Standard pairs (ETH/USDC) - most common
1%: Exotic pairs - low volume, high risk

Real Pool Performance Examples (January 2026)

ETH/USDC 0.3% Pool on Uniswap

Pool TVL: $180M
24h volume: $85M
24h fees: $255,000 (0.3% of volume)
7-day APY: ~16%

Your $10k = 0.0056% of pool = $14.25/day = ~52% APY
But: Subject to impermanent loss if ETH price moves

Pool Size Tradeoff

Smaller pools = higher share of fees but more impermanent loss risk and slippage. Larger pools = lower share but more stable.

Types of Pools

Standard Pools (50/50)

Equal value of both tokens
Used by Uniswap v2, SushiSwap
Simple but subject to impermanent loss

Concentrated Liquidity (Uniswap v3)

Provide liquidity in specific price ranges
Higher capital efficiency
More complex management required

Stable Pools

Optimized for similar-priced assets
Used by Curve for stablecoins
Lower fees, lower impermanent loss

Impermanent Loss

The key risk of providing liquidity:

Occurs when token prices diverge from when you deposited
Called "impermanent" because it can reverse if prices return
Becomes permanent when you withdraw

Impermanent Loss Example

Deposit $1000 ETH + $1000 USDC. ETH price doubles. If you held, you'd have $3000. In pool, you have ~$2450. That's 18% impermanent loss.

Major LP Platforms Compared (2026)

Platform	TVL	Specialty	Typical APY	IL Risk
Uniswap	$6.7B	All pairs, concentrated liquidity	5-25%	Medium-High
Curve	$4.2B	Stablecoins, like-assets	8-18%	Low
Balancer	$1.8B	Weighted pools (80/20, etc.)	6-20%	Medium
PancakeSwap	$2.1B	BNB Chain, low gas	10-40%	Medium-High

LP Horror Stories: When Fees Don't Cover IL

Case Study 1: ETH/SHIB Pool Disaster (2021)

The Numbers Don't Lie

Deposited May 2021: $10,000 ($5k ETH + $5k SHIB)
Withdrew December 2021: $6,200

SHIB crashed 82% vs ETH
Trading fees earned: $1,850
Impermanent loss: -$5,650
Net result: -$3,800 (-38%)

If held both tokens: $8,100 (ETH +20%, SHIB -70%)
LP underperformed holding by $1,900

Case Study 2: Successful Stablecoin LP (2023-2026)

When LP Works: Low Volatility Pairs

Curve 3pool (USDC/USDT/DAI) on Ethereum:
Deposited: $25,000
Duration: 3 years
Average APY: 11.5%
Total fees earned: $8,625
Impermanent loss: -$78 (0.3%)
Gas costs: $280
Net profit: $8,267 (33% over 3 years)

Result: Success because price stability minimized IL

Concentrated Liquidity: Higher Returns, Higher Risk

Uniswap v3 Range Orders

Provide liquidity only within price range
Capital efficiency: 4,000x better than v2
Example: ETH $2,800-3,200 range instead of $0-infinity
Earn MORE fees when price in range
Earn ZERO fees when price exits range

Real Concentrated Liquidity Returns

Range Width	Fees When Active	Time In Range	Management
Narrow (10%)	Very High (100-300% APY)	60-70%	Rebalance daily
Medium (25%)	High (40-100% APY)	85-90%	Rebalance weekly
Wide (50%)	Medium (15-40% APY)	95-98%	Rebalance monthly
Full Range	Low (8-20% APY)	100%	Set and forget

Gas Kills Narrow Ranges on Mainnet

Rebalancing a Uniswap v3 position costs $40-120 in gas. If you rebalance weekly:
- 52 rebalances/year
- $3,120-6,240 in annual gas costs
- Need $20k+ position to justify on Ethereum

Solution: Use Layer 2 (Arbitrum, Optimism) or automated managers like Gamma/Arrakis.

Advanced LP Strategies

Stablecoin Arbitrage LP

Provide liquidity to USDC/USDT on Curve
Minimal IL (both target $1.00)
Earn 8-12% APY + CRV rewards
Boost with veCRV to 15-20% APY
Stack on Convex for additional 3-5%

Correlated Asset LP

ETH/stETH, wBTC/renBTC pairs
Assets move together (low IL)
Earn fees + protocol incentives
Risk: De-peg events (see stETH June 2022)

50/50 Exposure LP

Want 50% ETH, 50% BTC exposure anyway
LP maintains this automatically
Earn fees for rebalancing you'd do anyway
Best when you're neutral on price direction

Withdrawing Liquidity: What to Expect

The Withdrawal Process

Burn LP tokens to receive underlying assets
Ratio changed from deposit due to trading
Fees automatically included in balances
Gas cost: $20-80 on Ethereum mainnet

Example Withdrawal After Price Change

ETH/USDC LP: Deposit vs Withdrawal

At Deposit (ETH = $2,000):
Provided: 2.5 ETH + $5,000 USDC = $10,000

At Withdrawal (ETH = $3,000):
Receive: ~2.04 ETH + ~$6,124 USDC = $12,244
Fees earned: $780
Total value: $13,024

If you held instead:
2.5 ETH at $3,000 = $7,500
Plus $5,000 USDC = $12,500

LP result: $13,024
Hold result: $12,500
LP won by $524 because fees exceeded IL

LP Risks Beyond Impermanent Loss

Smart Contract Exploits

Even audited AMMs can have bugs
Balancer hack (June 2020): $500k drained
No insurance - losses are permanent

Rug Pulls on New Pools

Scammers create fake tokens
Seed initial liquidity
Wait for others to add liquidity
Remove all liquidity, leaving others stuck

Oracle Manipulation

Flash loan attacks can manipulate prices
LPs can be drained in single block
Affects smaller, low-liquidity pools most