Providing liquidity
- Author
- CRYPTO PORT Editorial
- Published
- Updated
- Reading time
- 7 min
In short
Providing liquidity means depositing your assets into a pool so that other people's trades can execute against them. You share in the trading fees, but the further the two deposited assets diverge in price, the less you end up with than if you had simply held them — impermanent loss. On top of that sits the permanent risk that the contract holding your deposit fails.
Key points
- You normally deposit two tokens, in amounts of matching value
- Fee income and impermanent loss are separate ledgers, and the net can be negative
- Your deposit is held by a contract; a flaw or an abuse of it can take all of it
- You do not get back the amounts you put in — you get the pool's current ratio of them
Definition
Depositing two tokens into a DEX's liquidity pool so that other people's trades can settle against them, in return for a share of the trading fees.
Start from what you are signing up for. A DEX has no order book; the counterparty to every trade is the pool, and the pool is made of assets somebody deposited. Providing liquidity means entering a relationship where your assets are sold when others buy and bought when others sell. The fees are payment for filling that role.
In practice you pick a pool, then prepare the two tokens in amounts of roughly equal value — commonly one of them is a stablecoin or the chain's native asset. Each token needs its own approval transaction so the contract can move it, and each costs gas. Once deposited, the usual design issues you a token representing your share of the pool.
The concept you must understand before depositing is impermanent loss. A pool constantly rebalances toward a target ratio, so when one asset rises the pool sells it and accumulates the other. What you can withdraw is therefore weighted away from whatever went up and toward whatever went down. Compared with simply holding both, you end up with less, and that gap is the loss. It is called impermanent because it unwinds if prices return to the original ratio — but withdrawing before they do makes it permanent.
Set that against the fees. In an actively traded pool, fee income accumulates and can exceed the divergence loss. In a quiet pool where prices moved a lot, you can collect fees and still be behind. Which outcome you get is not knowable in advance, and any pitch that says 'you earn fees, so you profit' is describing one side of the ledger only.
Finally, the risk to the deposit itself. Your assets are held by a contract. If that contract has a flaw, or if a privileged party can move the funds, you can lose everything regardless of what prices did. Audits and a long operating history are inputs to the judgement, not guarantees that nothing will happen. Do not move away from the premise of depositing only what you can afford to lose entirely.
Watch out for
- · Deposits have been lost in full through contract flaws, abuse of admin privileges and manipulated price feeds. There are routes to losing everything that have nothing to do with price
- · Withdrawing while the two assets have diverged leaves you with less than holding would have. Fee income does not reliably cover the gap
- · Look-alike sites exist purely to collect approvals and deposits. Verify the official domain yourself and arrive via a bookmark
Frequently asked questions
If I deposit only one token, does impermanent loss go away?
Single-sided designs still convert or lend behind the scenes, which reintroduces the same divergence or substitutes a different risk. What changed is how simple the deposit screen looks, not what happens to the asset. Find out what your asset is actually being used for.