Liquidity Pools Explained (and the Impermanent Loss Nobody Mentions)

Here's a puzzle that catches a lot of people. Chiamaka puts some USDT and an equal value of ETH into a pool on a decentralised exchange. The dashboard shows a healthy yearly return. Three months later, ETH has doubled and the swap fees have been rolling in. Yet the position is worth less than if the same coins had simply sat in a wallet.

Nothing was hacked and nobody cheated. Chiamaka had met impermanent loss, the part of liquidity providing that most tutorials skip in a sentence. This post gives it the space it deserves, along with how pools work and what to check before you put money into a new one.

How a liquidity pool works

A normal exchange matches buyers with sellers through an order book. A decentralised exchange (DEX) built on an automated market maker, or AMM, works differently. It keeps two tokens in a smart contract, and traders swap against that pool directly.

Take a pool holding ETH and USDT. A trader who wants ETH puts USDT in and takes ETH out. The pool now holds more USDT and less ETH, so its formula raises the price of ETH inside the pool. The classic design keeps the two amounts multiplied together roughly constant, which is why you'll see it called the constant product formula, written as x × y = k.

The pool never checks an outside price. If its ETH price drifts below the price on other exchanges, arbitrage traders buy the cheap ETH until the prices line up again. That arbitrage keeps the pool honest. As you'll see, it's also where impermanent loss comes from.

Uniswap and PancakeSwap are well-known examples of exchanges that work this way.

What liquidity providers get

The tokens in a pool come from people called liquidity providers (LPs). To join, you deposit both tokens in the pool's current ratio, usually equal values of each. In return you get:

• LP tokens. A receipt that records your share of the pool. When you want out, you hand them back and receive your share of whatever the pool holds at that moment.
• A share of swap fees. Every swap pays a small fee set by the pool, and that fee is added to the pool. Your cut depends on your share and on how much trading the pool sees.
• Sometimes, extra reward tokens. Some protocols pay bonus tokens to attract liquidity. That's the yield farming covered in our guide to making money in yield farming. Those rewards are often paid in the protocol's own token, and its price can fall fast as everyone sells their rewards.

What's missing from that list is a guaranteed return. Fee income rises and falls with trading volume, and the yearly figure a dashboard shows is usually projected from recent activity. It isn't a promise.

Impermanent loss, with the maths

The prices below are made up to show how the maths works. They aren't real prices.

You deposit into an ETH/USDT pool when 1 ETH is worth $2,000:

• 1 ETH, worth $2,000
• 2,000 USDT
• Total: $4,000

Then ETH doubles to $4,000 on every other exchange. Arbitrage traders buy ETH from the pool until its price matches. When they've finished, your share of the pool holds roughly:

• 0.707 ETH, worth $2,828
• 2,828 USDT
• Total: $5,657

That looks like a good result until you compare it with doing nothing. Had you kept 1 ETH and 2,000 USDT in your wallet, you'd have $6,000. The pool left you $343 short, about 5.7%. That gap is impermanent loss.

What happened? The pool sold some of your ETH on the way up, because ETH was exactly what traders were buying from it. It works in reverse too. If ETH halves to $1,000 instead, the pool buys more ETH on the way down, and you again finish about 5.7% behind simply holding.

The bigger the move, in either direction, the bigger the gap. For a classic pool split 50/50:

How far one token's price moves against the other	Impermanent loss compared with holding
Up 25%	about 0.6%
Up 50%	about 2.0%
Doubles, or halves	about 5.7%
Triples	about 13.4%
Four times, or falls to a quarter	about 20%
Five times	about 25.5%

It's called impermanent because the gap closes if prices return to where they were when you deposited. It becomes permanent the moment you withdraw at a different price, and crypto prices rarely return politely to where you started.

Two more things worth knowing:

• Concentrated liquidity pools, where you choose a price range, can earn more fees from the same money. They also feel impermanent loss more sharply, and they stop earning fees entirely when the price leaves your range.
• Stablecoin pairs such as USDT/USDC have very little impermanent loss while both coins stay near $1. Their risk is different: if one loses its peg, everyone sells it into the pool, and providers end up holding mostly the weaker coin.

Do the fees make up for it?

Sometimes. You come out ahead only if the fees and rewards you earn are bigger than the impermanent loss, plus the network fees you paid to deposit and withdraw.

Pools tend to work better for providers when:

• the two tokens usually move together, such as two stablecoins;
• trading volume is high compared with the size of the pool;
• you stay long enough for fees to build up, and your deposit is big enough that network fees are a small slice of it.

They tend to work worse when one token is volatile and trending hard in one direction. Unfortunately, that's exactly when a new token's pool shows its most exciting yield.

A quick test before you deposit: ask how far the pair would need to move for impermanent loss to cancel out a month of fees at the current rate. If a doubling looks plausible and a month of fees wouldn't cover 5.7%, the headline figure is flattering you.

New pools and rug pulls

Anyone can create a pool for any token, and many scams start that way. Someone launches a token, pairs it with USDT or BNB, advertises an enormous yield and waits for deposits. Then one of three things happens:

• The liquidity disappears. The creator holds most of the LP tokens, withdraws them and walks off with the real coins, leaving everyone else holding a worthless token.
• Nobody can sell. A "honeypot" contract lets people buy but blocks selling.
• The supply balloons. A hidden function lets the creator mint new tokens and dump them into the pool.

Before you go near a new pool, check five things:

1. Is the token's contract verified and readable on a block explorer?
2. Are the creator's LP tokens locked, for how long, and by what? A lock that ends next week means very little.
3. Who holds the supply? A handful of wallets holding most of it is a warning.
4. Does the project have a track record, and are the people behind it known?
5. Are other people successfully selling? Look at recent transactions for sells, not just buys.

Our guide to spotting a rug pull goes into more detail. And remember that each time you add liquidity, you approve the exchange's contracts to move your tokens. Review those permissions every so often and remove the ones you no longer need, as shown in how to revoke token approvals.

A sensible way to learn by doing

If you want to try it:

• Start with an amount you could lose entirely without it hurting, in a pool between two widely used tokens on an established DEX.
• Use a separate wallet for DeFi, never the one holding your savings.
• Write down what you deposited, the prices at the time and every network fee. Without those notes, you can't tell whether the fees really beat impermanent loss.
• Every few weeks, compare your position with what simply holding would be worth. The crypto profit calculator helps with the holding side of that sum.

This is general education, not financial advice. Smart contracts can have bugs, and money in a pool can be lost.

Getting back to naira

When you withdraw from a pool, you get both tokens back in their new ratio. If you want naira, swap into a coin that's easy to sell, such as USDT, and send it to your KWIQ wallet on the network the app shows. Selling crypto for naira on KWIQ has zero fees, and you see the rate and the naira amount before you confirm.

Check which coins and networks KWIQ accepts before you send anything, because many DeFi tokens, and some networks, aren't accepted by cash-out apps at all.

When you're ready, download the KWIQ app, or create a free account on the web if your phone is short on space.