What Is Providing Liquidity?
Providing liquidity involves making assets available under specific rules so that other users can trade in a market.
On this page
- What do you own when you deposit money into a pool?
- Why do swaps change your balance?
- How is fee income calculated?
- What does choosing a price range mean?
- Process sequence on the add liquidity screen
- Which amount should you compare at exit?
- Is pool size a guarantee of safety?
- Adding liquidity to a pool is different from buying tokens
- Sources
A liquidity pool is a structure where assets are brought together in a smart contract to enable trading. A person who deposits assets into a pool is called a liquidity provider, or LP for short. The primary objective is usually to earn fees from the swaps that occur. In return, the amount of assets held by the provider changes with price movements; earning fee income does not mean the value of the deposited money will be preserved.
What do you own when you deposit money into a pool?
In a simple two-asset pool, users deposit two tokens at a certain ratio. In exchange, they receive a record representing their share in the pool. In some systems, this record is a fungible LP token, while in others, it is an NFT representing a specific price range. Here, an NFT is not an image collection but a distinctive record of the liquidity position. How rights are represented varies depending on the protocol used.
For example, if you add $10,000 worth of assets to a pool with a total value of $100,000, all other conditions being constant, the new total becomes $110,000. Your share is approximately 9.09%, not 10%. Fee distribution may not be explained by this simple ratio alone. In pools using concentrated liquidity, the price range and the amount of active liquidity within that range also affect earnings.
Why do swaps change your balance?
Imagine you deposit assets into an ETH/USDC pool. As users buy ETH from the pool, the amount of ETH decreases and USDC increases. When you withdraw your share of assets from the pool, you may not receive the same amounts you initially deposited. Providing liquidity produces a different economic result than simply holding two assets in a wallet without touching them.
This change does not occur simply because the price is updated on the screen; it is a result of the pool’s trading mechanism. As ETH rises, a portion of the ETH in your position may be converted to USDC through swaps. Therefore, even if the dollar value of the portfolio increases, it may result in a lower value compared to holding the same ETH and USDC in a wallet. This relative difference is examined separately under the heading of impermanent loss.
How is fee income calculated?
Consider a hypothetical pool that facilitates $200,000 worth of swaps in a day and the total swap fee is 0.30%. The gross fee is $600. In a simple model where all of this amount is allocated to providers and your active liquidity share is 1% throughout the day, your share would be $6. In a real system, protocol cuts, changing shares, price ranges, and different fee tiers can change the outcome.
You cannot find a definitive annual income by multiplying one day’s earnings by 365. The next day, volume may drop, new capital may enter the pool, or the price may move out of your range. The value of additional tokens distributed as incentives may also change. Viewing fee income and reward token income separately makes it easier to understand which source produces high annual rates.
What does choosing a price range mean?
In concentrated liquidity, a provider opens their capital for use within a certain price range. For example, a position can be selected that offers liquidity for transactions where the ETH price is between $2,000 and $3,000. When the price moves outside this range, the position may not actively participate in swaps and may stop earning fees. During this process, the assets within the position may also predominantly convert into a single asset.
A narrower range can allow the same capital to be used more intensely at specific prices. However, it also becomes easier for the price to exit the range. Changing the range is not a free setting: closing the old position, swapping for the new ratio, and re-depositing can create costs. It would be incomplete to evaluate the difference between a wide range and a narrow range based solely on the displayed yield percentage.
Process sequence on the add liquidity screen
First, find the correct pool on the correct network. Verify token names with contract addresses; pools with similar names may not contain the same assets. Then, select the fee tier and, if applicable, the price range. Review the two asset amounts requested by the interface, the network fee, and spending permissions. Creating a pool is not the same process as adding liquidity to an existing pool; additional responsibilities, such as determining the initial price, may arise.
Once the transaction is complete, verify your position through the liquidity section of the application and the blockchain record. Saving the network used, the contract address, and the position ID makes it easier to access the correct position later. If you deposit the LP token into another reward contract, you are trusting a second contract. You may need to exit this second contract first to withdraw.
Which amount should you compare at exit?
Compare the current value of the assets you initially deposited with the total of the assets you can withdraw plus accumulated fees. For example, if the initial basket is worth $12,000 today but $11,700 comes out of the position including fees, even though there is a gain relative to your initial $10,000 investment, you are $300 behind compared to holding. In this example, network and rebalancing costs have not yet been deducted.
Collecting fees and withdrawing principal are separate steps in some protocols. Check which items are included in the total position value shown by the application. There is also a difference between obtaining two assets at exit and converting all of them into a single asset; fees and price impact may occur again during the final swap. Keeping records to cover all these stages allows you to see the real result.
Is pool size a guarantee of safety?
High total value does not prevent smart contract errors, a stablecoin depegging from its value, or the compromise of administrative keys. In a pool with two stablecoins, prices are expected to remain close; however, if confidence in one is shaken, users may withdraw the asset they perceive as stable from the pool. The provider may become concentrated in the more problematic asset. Using two assets with prices close to each other does not create a risk-free deposit product.
Adding liquidity to a pool is different from buying tokens
If you only want to participate in the price increase of a single token, a two-asset pool position does not produce the same result. The ratios in the pool change with swaps, and you may receive different amounts of the two assets upon exit. For example, as the ETH price rises, your pool share may contain more stablecoins and less ETH. Whether fee income compensates for this difference is calculated separately. Therefore, do not think of the “deposit” button on the liquidity providing screen as buying a single asset on an exchange. It is first necessary to understand which assets the position can turn into under different price scenarios.