DeFi and Market Structure · Crypto Trading Guide

Providing liquidity changes the mix of assets you hold. Fee income must be compared with the value of simply holding the starting assets.

Choose the correct comparison

A liquidity provider supplies assets to support swaps and may earn fees. As relative prices change, the pool changes the quantities represented by the position. Compare the final pool claim with holding the original quantities outside the pool, using the same final prices. A dollar profit can still underperform that holding benchmark.

Work through a simplified pool

Suppose an illustrative constant product pool starts with 1 A worth $100 and $100 of B, with B assumed fixed at one dollar. Total starting value is $200. If A doubles to $200 and arbitrage restores the pool ratio, reserves become about 0.7071 A and 141.4214 B without fees. Their total value is about $282.84. Simply holding 1 A and 100 B would be worth $300. The pool underperforms by about $17.16, or 5.72% of the holding benchmark.

Understand the name’s limitation

The term impermanent loss refers to this relative difference, not a promise that the loss will reverse. Exiting can crystallise the comparison, and the assets themselves can lose value. Fees may offset some divergence but are uncertain. Contract failure, depegging and token restrictions are separate risks not captured by the simplified formula.

Account for a chosen range

Concentrated liquidity allocates capital within selected price bounds. It can increase exposure and fee efficiency within that range, but the position may become entirely one asset outside it and stop earning ordinary active range trading fees. Moving the range incurs execution and network costs. Do not use the simple full range example as an exact formula for a concentrated position. Evaluate the actual range, inventory, fees and rebalancing policy together.

Try it yourself

The example pool earns $10 of additional fees with no other costs. Does it now outperform holding?

Show the worked answer

No. Its value would be about $292.84 versus $300 for holding, still about $7.16 lower under the simplified assumptions.

Further reading

Educational material. Examples and rates are hypothetical, not trade recommendations. Product terms, eligibility and risks vary by venue and jurisdiction.

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