🏊🏻‍♂️ Liquidity Pools

**What are liquidity pools:** Liquidity pools are smart contracts that hold reserves of two tokens to facilitate trading. They're the backbone of decentralized exchanges.

The economic model:

For traders:

• Pools provide instant liquidity for swaps

• No need to wait for matching orders

• 24/7 availability

For liquidity providers (LPs):

• Earn trading fees (typically 0.3% per swap)

• Fees are distributed proportionally to pool share

• Receive LP tokens representing your position

• Can withdraw liquidity anytime

How to add liquidity:

1. Navigate to Pools page

2. Click "Add Liquidity"

3. Select first token (e.g., ETH)

4. Select second token (e.g., USDC)

5. Enter amounts:

   • Must provide equal value of both tokens

   • Example: $500 worth of ETH + $500 USDC

   • Interface auto-calculates based on current price

1. Review position details:

   • Your pool share percentage

   • Expected annual returns (APR)

   • Current pool statistics

2. Confirm transaction

3. Receive LP tokens: These represent your share

Understanding liquidity provision:

Your pool share:

• If pool has $1M and you add $10k, you own 1%

• You earn 1% of all trading fees

• If pool generates $100k in fees annually, you earn $1k

Price ratio:

• Pools maintain 50/50 value split

• If ETH price rises, pool automatically rebalances

• This leads to impermanent loss

Impermanent Loss (IL): What it is: The opportunity cost of providing liquidity vs. holding tokens

How it occurs:

• You add 1 ETH ($2000) + 2000 USDC to a pool

• Pool ratio: 1 ETH = 2000 USDC

• ETH price rises to $3000

• Pool rebalances automatically

• You now have 0.816 ETH + 2449 USDC = $4449

• If you had just held: 1 ETH ($3000) + 2000 USDC = $5000

• Impermanent loss: $551 (11%)

Why "impermanent":

• If price returns to original ratio, loss disappears

• Loss is only realized when you withdraw

• Trading fees can offset the loss

Formula:

IL = (2 × √price_ratio) / (1 + price_ratio) - 1

IL examples by price change:

• 1.25x price change: -0.6% loss

• 1.50x price change: -2.0% loss

• 2x price change: -5.7% loss

• 5x price change: -25.5% loss

• 10x price change: -42.0% loss

Strategies to minimize IL:

1. Provide liquidity to stable pairs: USDC/USDT has minimal IL

2. Correlated assets: ETH/stETH moves together

3. High-fee pools: Trading volume can offset IL

4. Long-term provision: Time heals price volatility

APR calculation:

APR = (Daily Fees × 365) / TVL × 100

Example:

• Pool TVL: $10,000,000

• Daily trading volume: $1,000,000

• Fee per trade: 0.3%

• Daily fees: $3,000

• Annual fees: $1,095,000

• APR: 10.95%

Real-world considerations:

• Top pools on Uniswap have billions in TVL

• APRs range from 5% (stable pairs) to 100%+ (volatile pairs)

• Gas fees for adding/removing liquidity can be $50-200 on Ethereum

• Layer 2 solutions reduce fees to pennies