Classic AMM Liquidity Pools

How does a Liquidity Pool Work?

A liquidity pool (LP) is essentially a smart contract that holds two tokens, e.g. MOE and MNT tokens. Liquidity pools are there to facilitate trading between the two tokens that make up the liquidity pool, replacing the traditional role of market makers on centralized exchanges. In a decentralized exchange, trades are facilitated by an automated market maker (AMM) system, which uses algorithms within smart contracts to execute trades initiated by users.

In essence, a liquidity pool enables the automatic and permissionless exchange of two tokens through the use of smart contracts.

Why Deposit Liquidity into a Liquidity Pool?

Users can earn a share of the trading fees by depositing a pair of tokens into the LP (also known as "adding liquidity"). Users will receive an LP token, representing their stake in the pool.

Pool APR

Pool APR is the yield you accrue by adding liquidity to a pool. You earn 0.25% of all trades using this pair, proportional to your share of the pool. These fees are added to the pool, accrue in real-time, and can be claimed when you withdraw your liquidity. Providing liquidity is not without risk, as you may be exposed to impermanent loss (IL).

If the prices of the two tokens revert back to the same prices when you added liquidity, you won't suffer any IL.

Impermanent Loss (IL)

Participating in a liquidity pool does come with the risk of impermanent loss.

Impermanent loss is a potential temporary reduction in value that occurs when you provide liquidity. It represents the difference between simply holding your assets versus actively participating in liquidity provision.

How does Impermanent Loss Happen?

Impermanent Loss occurs when the price ratio of the supplied token pair changes. As a simple rule, the greater the volatility of the assets in the pool, the higher the risk of incurring impermanent loss. AMMs maintain a constant ratio of liquidity within a pool, automatically adjusting holdings to preserve balance. These adjustments can lead to impermanent loss over time.

The term 'impermanent' suggests that the loss could be reversed if the token's price returns to its original state within the pool. If the price does realign, the impermanent loss vanishes. However, if you choose to withdraw your liquidity, any loss becomes permanent.