Decentralized finance (DeFi) has revolutionized the way users interact with financial systems, and at the heart of many DeFi protocols lies the automated market maker (AMM) model. One of the most critical components of AMMs is the liquidity pool (LP) — a smart contract-based mechanism that powers decentralized trading without relying on traditional order books or centralized market makers.
In this guide, we’ll explore how classic AMM liquidity pools work, why users participate in them, and the risks and rewards involved — particularly focusing on trading fees, APR, and impermanent loss (IL).
How Does a Liquidity Pool Work?
A liquidity pool is a smart contract that holds two tokens in a paired reserve, such as MOE/MNT. These pools enable seamless, automated token swaps on decentralized exchanges (DEXs), removing the need for buyers and sellers to be matched manually.
Instead of relying on order books like centralized exchanges, AMMs use mathematical formulas — typically a constant product formula like x × y = k — to determine prices based on the ratio of tokens in the pool. When a user swaps one token for another, the smart contract automatically adjusts the reserves and updates the price accordingly.
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This system allows for permissionless, continuous liquidity, meaning anyone can trade at any time, and anyone can contribute tokens to earn rewards.
Why Deposit Liquidity Into a Pool?
Users who deposit an equivalent value of both tokens into a liquidity pool are known as liquidity providers (LPs). In return for locking up their assets, they receive LP tokens, which represent their proportional share of the total pool.
These providers play a crucial role in maintaining market efficiency by ensuring there’s always enough liquidity for traders to execute swaps with minimal slippage.
In exchange for this service, LPs earn a portion of the trading fees generated from every swap that occurs within the pool. On many platforms, this fee is typically set at 0.25% per trade, distributed proportionally based on each provider’s stake.
Over time, these small fees accumulate and can result in significant returns — especially in high-volume pools.
Understanding Pool APR
Pool APR (Annual Percentage Rate) reflects the estimated yearly return you could earn by providing liquidity to a specific pool. This rate is dynamic and fluctuates based on:
- Trading volume within the pool
- Total liquidity locked (TVL)
- Fee distribution mechanics
For example, if a pool sees heavy trading activity but has relatively low total liquidity, individual LPs may enjoy higher APRs due to a larger share of fees relative to their contribution.
However, it’s important to remember that APR does not account for risk — particularly impermanent loss (IL), which can significantly impact net returns.
While high APRs might look attractive, savvy investors evaluate both potential gains and downside exposure before committing funds.
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What Is Impermanent Loss?
One of the most misunderstood yet essential concepts in DeFi is impermanent loss (IL). It refers to the temporary decline in value experienced by liquidity providers when the price of deposited tokens changes compared to holding those assets outside the pool.
When Does Impermanent Loss Occur?
Impermanent loss happens when the market price of one or both tokens in the pair diverges from the price at the time of deposit. Because AMMs maintain a fixed ratio of token values (e.g., 50:50), the smart contract automatically rebalances holdings through arbitrage.
Let’s say you deposit MOE and MNT when their prices are stable. If MOE suddenly surges in value on external markets, arbitrageurs will buy cheap MOE from the pool until prices align again. This results in the pool containing more MNT and less MOE — meaning your share now has fewer units of the appreciating asset.
As a result, you end up with a lower overall value than if you had simply held the tokens in your wallet.
Key Insight: The greater the price volatility between the two assets, the higher the potential for impermanent loss.
Is Impermanent Loss Really "Impermanent"?
The term “impermanent” is used because the loss only becomes real if you withdraw your funds while prices remain unbalanced. If the token prices return to their original ratio at the time of deposit, the loss effectively disappears — hence, it was never truly realized.
However, if you choose to exit the pool during a period of divergence, the loss becomes permanent, and you cannot recover it.
This makes timing and asset selection critical factors for successful liquidity provision.
Mitigating Risks While Maximizing Returns
While impermanent loss is unavoidable in volatile markets, there are strategies to reduce its impact:
- Provide liquidity for stablecoin pairs (e.g., USDC/USDT) – minimal price fluctuation means negligible IL.
- Choose correlated asset pairs – tokens that tend to move together (like two Layer 1 ecosystem tokens) reduce imbalance risk.
- Monitor pool performance regularly – track APR trends, TVL changes, and external price movements.
- Factor in incentives – some platforms offer additional yield through token rewards or staking bonuses, which can offset potential IL.
Ultimately, successful liquidity provision isn’t just about chasing high APRs — it’s about balancing reward potential with risk tolerance.
Frequently Asked Questions (FAQ)
What is a liquidity pool in DeFi?
A liquidity pool is a crowdsourced reserve of tokens locked in a smart contract, used to facilitate decentralized trading on AMM-based exchanges. Users add funds to these pools to earn trading fees proportional to their contribution.
How do I start providing liquidity?
To provide liquidity, visit a decentralized exchange that supports AMMs (like Merchant Moe), select a token pair, deposit equal values of both tokens, and receive LP tokens representing your share. You can withdraw your assets plus accumulated fees at any time.
Can I lose money in a liquidity pool?
Yes — while you earn trading fees, you’re exposed to impermanent loss if token prices change significantly. In extreme cases, losses from IL can outweigh fee earnings, resulting in a net negative return.
Does impermanent loss mean I lose my tokens?
No. Impermanent loss doesn’t mean your tokens disappear — you always retain ownership of both assets in your share. It simply means that the value of your combined holdings may be less than if you had held them separately outside the pool.
Are all liquidity pools risky?
Not equally. Pools with stablecoins or highly correlated assets carry much lower risk of impermanent loss. High-volatility pairs (e.g., new altcoins) offer higher potential yields but come with increased risk.
How are trading fees distributed in a liquidity pool?
Each trade incurs a small fee (commonly 0.25%), which is added directly to the pool. This increases the total reserves over time. When you withdraw your liquidity, you receive your share of both the original assets and accumulated fees.
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By understanding how classic AMM liquidity pools operate — from fee structures to risk factors like impermanent loss — you can make informed decisions that align with your investment goals. Whether you're seeking passive income or deeper engagement with DeFi protocols, liquidity provision remains one of the most accessible entry points into decentralized finance.
Just remember: always assess volatility, calculate potential returns realistically, and never invest more than you’re willing to risk.