Module 9: DeFi Deep Dive
Providing Liquidity
Chapter 3 of 14 · about 5 minutes
3.1 Becoming the market
"Every time you swap on a DEX, someone provided the tokens you traded against," said Hash. "What if that someone was you?"
Mint was interested. "So I'd earn the fees traders pay?"
"A share of them, yes," said Hash. "Liquidity providers are the market makers of DeFi. It can be a good business. It can also be a way to slowly lose money while thinking you're earning. The difference comes down to fees, volatility, and something called impermanent loss, which is the next chapter."
3.2 How liquidity provision works
A liquidity provider (LP) deposits tokens into a DEX pool. In return, the LP receives a record of their share of the pool:
| Pool type | What the LP receives |
|---|---|
| Full-range pools | LP tokens, fungible tokens representing a share of the pool |
| Concentrated liquidity pools | A position, often an NFT, recording the specific range and amounts |
When traders swap through the pool, they pay fees, which are added to the pool or tracked for the LP. When the LP withdraws, they receive their share of the pool's tokens, plus earned fees.
In a two-token pool, LPs usually deposit both tokens in the pool's current ratio. For an ETH/USDC pool with ETH at $3,000, an LP might deposit 1 ETH and 3,000 USDC, worth $6,000 in total.
3.3 How much do LPs earn?
Fee income depends on three numbers: how much trading happens, the fee rate, and how much liquidity shares the fees.
Pool fee income = trading volume × fee rate
Fee APR (approximate) = annual fee income ÷ pool liquidity
| Example ETH/USDC pool | Value |
|---|---|
| Pool liquidity (TVL) | $10,000,000 |
| Daily trading volume | $5,000,000 |
| Fee rate | 0.30% |
| Daily fees | $15,000 |
| Annual fees (if volume stays the same) | ~$5,475,000 |
| Fee APR | ~55% |
Mint's $6,000 is 0.06% of the pool, so Mint would earn about $9 a day in fees at this rate.
The key ratio is volume to TVL. A pool with high trading volume relative to its liquidity generates high fee APR for LPs. As more LPs join, the same fees are shared among more capital, and APR falls.
"55% sounds incredible," said Mint.
"It's a fee figure, before costs," said Hash. "The real question is what you lose to price changes while you're earning it. Sometimes 55% in fees isn't enough."
3.4 Who LPs trade against
Liquidity providers are, in effect, always ready to trade with anyone at the pool's price. That means LPs trade against two very different groups:
| Counterparty | What happens to LPs |
|---|---|
| Ordinary users swapping tokens | LPs earn fees, roughly neutral otherwise |
| Arbitrageurs correcting the pool's price | LPs sell the rising asset too cheaply and buy the falling asset too expensively, losing value |
When ETH's price rises on centralised exchanges, the pool's price lags. Arbitrageurs buy ETH from the pool at the old, cheaper price until it catches up (Module 1, Chapter 8). The LPs sold that ETH for less than it was worth elsewhere. This repeated loss to better-informed traders is what drives impermanent loss.
"So LPs are like a shop that never updates its prices until a customer points out they're too low," said Node.
"And the customers who point it out are buying everything that's underpriced first," said Hash.
3.5 Concentrated liquidity positions
In concentrated pools (Chapter 2), LPs choose a price range.
| Range choice | Fees while in range | Risk of leaving range | Management |
|---|---|---|---|
| Narrow ($2,900 to $3,100) | Very high | High; small moves take it out of range | Frequent adjustments |
| Medium ($2,500 to $3,500) | Moderate | Moderate | Occasional adjustments |
| Wide or full range | Lower | Low | Minimal |
When price leaves the range, the position stops earning fees and holds only one token: all ETH if price fell below the range, all USDC if it rose above. Adjusting the range means withdrawing and re-depositing, which costs gas and may lock in losses.
Many LPs in concentrated pools use automated liquidity managers, protocols that adjust ranges on their behalf. These add convenience, but also smart contract risk and their own fees.
3.6 Choosing pools
| Pool type | Fee potential | Price risk | Typical LP profile |
|---|---|---|---|
| Stablecoin pairs | Low | Low, unless a depeg | Conservative |
| Correlated pairs, like ETH and liquid staking ETH | Low to moderate | Low, unless a depeg | Conservative to moderate |
| Major volatile pairs, like ETH/USDC | Moderate to high | Moderate to high | Active, experienced |
| Small or new tokens | Very high, often with incentives | Very high | Speculative |
3.7 The full picture of LP returns
LP return ≈ fees earned + incentives received − impermanent loss − gas and management costs
Compared with simply holding the two tokens, an LP position is profitable only if fees and incentives outweigh impermanent loss and costs. The next chapter shows how to calculate impermanent loss, and when fees are enough to cover it.
3.8 Try it yourself
Find a DEX analytics page for an ETH/USDC pool and a stablecoin pool. For each, note the TVL, 24-hour volume, and fee tier. Calculate the approximate fee APR using the formula in section 3.3. Then check the same pools' volume and TVL a week later. How stable was the fee APR?
Key takeaways from this chapter
- Liquidity providers deposit tokens into pools and earn a share of trading fees.
- Full-range LPs receive fungible LP tokens; concentrated LPs hold positions, often as NFTs.
- Fee APR depends on trading volume, fee rate, and pool liquidity; volume relative to TVL is the key ratio.
- LPs trade against both ordinary users and arbitrageurs, and lose value to arbitrageurs when prices move.
- Concentrated liquidity earns more in range but requires management and stops earning out of range.
- LP returns equal fees plus incentives, minus impermanent loss and costs.