How Liquidity Pools Work, and What Impermanent Loss Costs

A traditional exchange matches buyers with sellers through an order book. Most decentralised exchanges skip the matching entirely. You trade against a pool of tokens, and a formula decides the price.

How does a pool set a price?

The simplest and most influential design, popularised by Uniswap, is the constant-product formula: x × y = k. A pool holds two tokens, say ETH and USDC. The amounts multiplied together must stay the same after every trade, apart from fees.

If you buy ETH from the pool, you add USDC and remove ETH. With less ETH left, each remaining unit costs more USDC to keep the product constant. The price moves because the balance of the pool has changed. Bigger trades relative to the pool size move it more. That effect is called slippage, and it's why thin pools quote poor prices for large orders.

The pool doesn't know the "real" price of ETH. If its price drifts from other venues, arbitrage traders buy the cheap side or sell the expensive side until it lines up again. This is the same mechanism that makes prices differ slightly between apps, and arbitrage is what keeps the gaps small.

Who supplies the tokens?

Liquidity providers (LPs). Anyone can deposit both tokens in the current ratio and receive LP tokens representing their share. Every trade pays a fee, commonly 0.3% on the classic design and lower on stablecoin pools, and that fee accrues to the pool. LPs collect it in proportion to their share.

Newer designs change the details. Concentrated liquidity lets LPs choose a price range, earning more fees per dollar while the price stays in range and nothing outside it. Stable-swap curves keep near-pegged assets trading tightly. The basic deal doesn't change: you supply inventory, you earn fees, you take on price exposure.

What is impermanent loss?

The pool always rebalances against you. When ETH rises, traders buy ETH out of the pool, so you end up holding less of the token that went up and more of the one that didn't. When it falls, the pool is filled up with the falling token.

Compare withdrawing from the pool with simply having held the two tokens, ignoring fees, for a standard 50/50 pool:

The loss is the same whichever direction the price moves. A halving costs the same as a doubling. It's called impermanent because if the price returns to where you entered, the loss disappears. In practice prices rarely return exactly, and withdrawing makes it permanent.

When is providing liquidity worth it?

When fee income beats the impermanent loss plus the gas you spend. That tends to favour:

• Pairs that move together, like two stablecoins or a token and its liquid-staking version, where impermanent loss stays small.
• High volume relative to pool size, so each dollar you deposit earns many trades' worth of fees.
• Timeframes where you'd hold both tokens anyway, so the comparison with holding is meaningful.

Be wary of headline APYs. Advertised yields often include reward tokens whose price is falling, and they're quoted before impermanent loss. A pool paying 40% in an emissions token that halves in value isn't paying 40%.

There's also contract risk on top. A pool is a smart contract, and pools are a favourite target for exploits, sometimes funded with flash loans.

How do you keep track of an LP position?

This is where many portfolios quietly go wrong. Your wallet holds an LP token rather than the two tokens it represents, and the LP token often has no market price. A tracker that can't read the pool will either miss the position or value it wrongly. If your total looks off after you've provided liquidity, start with why balances go wrong and tracking staked, pooled and lent assets.