TL;DR: Providing liquidity means depositing two tokens into a pool on a decentralised exchange and receiving a share of the trading fees. You face the risk of impermanent loss, bugs or hacks in smart contracts and fraud. There is no deposit guarantee and the income is variable.
What can you expect?
- Time per week
- About 1 to 3 hours a week to check your position and messages, plus extra time for the initial setup and learning.
- Starting capital
- No fixed minimum, but network (gas) fees weigh heavily on small amounts. Only deposit an amount you can lose entirely, for example a small part of your risk capital.
- Typical setbacks
- Impermanent loss in strong price moves, reward tokens that fall in value, hacks or fraud in which your entire deposit disappears, and a pool that earns less than the costs.
- Costs
- Network (gas) fees for depositing, claiming and withdrawing, trading costs in the pool, possibly fees for transferring and swapping tokens through a provider, and spread when swapping. Compare the total costs.
- Not suitable if…
- People who need their money, cannot bear losses, have no experience with wallets and smart contracts or expect a fixed income. Beginners are better off not starting.
How it works
On decentralised exchanges (DEXs) you do not trade through an order book but against a 'liquidity pool': a smart contract holding two tokens. Anyone providing liquidity deposits both tokens into the pool and receives a share of the trading fees. Sometimes reward tokens come on top. The risks are large: impermanent loss (a loss compared with simply holding when prices diverge), bugs or hacks in smart contracts, fraud such as rug pulls, and reward tokens that quickly lose value. There is no deposit guarantee and usually no supervisor or complaints body. The yields you see are variable and not a promise. This is education, not investment advice.
Core principles
- 1. Understand impermanent loss before you start
- 2. Only deposit an amount you can lose entirely
- 3. Prefer large, long-running protocols with independent audits, which are still not error-free
- 4. Count all costs: network (gas) fees, transaction costs and costs of entering and leaving
Step-by- step plan
- 1
Decide whether this suits you
This is very high risk and technical. Decide in advance the amount you can lose entirely and fix it. Only use money you do not need.
- 2
Choose a protocol and a pool
Read about the protocol: age, audits, history and how it is governed. An audit is not a guarantee. Check the website and the contract address through official sources to avoid fake sites.
- 3
Work out impermanent loss and costs
Use the formula to calculate what a price move of, say, 50% or 100% costs in impermanent loss. Also include network fees for depositing, claiming and withdrawing. If the expected income is not clearly above these costs, do not start.
- 4
Deposit liquidity and follow your position
Give approval and deposit both tokens at equal value. Follow your position, the income, impermanent loss and messages from the protocol. Only approve the amount you need.
- 5
Claim, review and leave when it no longer adds up
Claim rewards when the costs justify it. Review your position at fixed moments. Leave on a security problem, a sharply shrinking pool or when the income no longer justifies the costs and risk. Revoke old approvals.
In detail
How a liquidity pool works
On a decentralised exchange (DEX) you trade against a pool: a smart contract with two tokens, for example ETH and a stablecoin. A rule in the contract sets the price based on the ratio of tokens in the pool. On many DEXs, the product of the two quantities stays constant (x × y = k).
Anyone providing liquidity deposits both tokens at equal value and receives a receipt (LP token). On each trade the trader pays a small fee to the pool, shared among providers in proportion to their stake. The size of that fee differs by pool and protocol. Sometimes reward tokens come on top.
Impermanent loss
Impermanent loss is the difference between the value of your pool stake and the value of the tokens had you held them. It arises because the pool automatically rebalances your tokens as the price changes. You end up with more of the token that is falling in value.
Formula: IL = 2√r / (1 + r) − 1, where r is the change in the price ratio (2 means the price doubles). At r = 2, IL is −5.7%, at r = 4 it is −20%. The word 'impermanent' suggests it recovers if prices come back. That does not always happen, and if you leave in between, the loss is permanent. The worked example below works this out.
Stable and volatile pairs
In a pool of two stablecoins, impermanent loss is small but not zero: a stablecoin can lose its peg to the euro or dollar and then quickly lose a lot of value. In a pool with a volatile token (such as ETH and a stablecoin), impermanent loss is larger, and it can exceed the fees received. A high displayed annual yield (APY) is a snapshot and can change quickly.
Protocol and smart contract risk
Smart contracts contain code that can have bugs. Hacks, flash-loan attacks and abuse of admin keys happen, including at protocols with audits. An audit is not a guarantee. New or unknown protocols and tokens can be fraud (a rug pull): the creators pull the liquidity out.
Reduce the risk by using a separate wallet and a small amount, checking contract addresses through official sources and revoking old approvals. A fully decentralised protocol usually has no supervisor or complaints body and there is no deposit guarantee. For tax on income, see belastingdienst.nl.
- Experience with wallets and smart contracts
- Understanding of impermanent loss and smart contract risk
- An amount you can lose entirely
- A separate wallet for DeFi
- A calculator or spreadsheet for impermanent loss
- A record of transactions for your tax return
- 01 Only use money you can afford to lose and a separate wallet for DeFi
- 02 Check the contract address through the protocol's official source
- 03 Read about audits, the age and the history of the protocol
- 04 Work out impermanent loss in advance for a price move of, say, 50% and 100%
- 05 Start with a small amount to learn the process
- 01 Remove your liquidity if the protocol reports a security problem
- 02 Remove your liquidity if the income no longer justifies the costs and the risk
- 03 Review your position if the pool shrinks sharply
- 04 Revoke old approvals for smart contracts you no longer use
Worked example
Made-up worked example (not advice, not a forecast). You deposit €5,000 in ETH and €5,000 in a stablecoin into a pool (total €10,000). ETH costs €2,000, so you deposit 2.5 ETH. Then the ETH price doubles to €4,000 (r = 2). We leave out network fees and tax.
Formula: IL = 2√r / (1 + r) − 1.
- IL = 2 × √2 / 3 − 1 = −5.72%
- Had you held (2.5 ETH + €5,000): 2.5 × €4,000 + €5,000 = €15,000
- Value in the pool: €15,000 × (1 − 0.0572) = €14,142 (the pool now holds about 1.77 ETH and €7,071 in stablecoin)
- Impermanent loss: €15,000 − €14,142 = €858
Income from trading fees: suppose over a year you receive 6% on your €10,000 deposit, so €600 (an assumption, not an expectation). Then you have €14,142 + €600 = €14,742. That is €258 less than if you had held (€15,000). Trading fees would have to yield about 8.6% of your deposit (€858 / €10,000) to make up the impermanent loss.
If the price stays the same, there is no impermanent loss and you keep the €600. If the pool falls victim to a hack, you can lose everything. A rise in ETH does not mean here that you are better off than by holding.
Hypothetical example, not advice.
Work it out yourself
Risks and risk management
- Impermanent loss: if the prices of the two tokens diverge, you end up with less value than if you had simply held them
- Smart contract risk: bugs or hacks can cost you your entire deposit, even at protocols with audits
- Fraud such as rug pulls and fake sites (phishing)
- Reward tokens can lose value quickly
- No deposit guarantee and usually no supervisor or complaints body
- MiCA applies to crypto service providers. Fully decentralised services without an intermediary often fall outside that supervision in practice, and MiCA does not regulate the price of tokens
- Network (gas) fees can eat a large share of your income on small amounts
- A high displayed yield (APY) is variable and can signal high risk or temporary rewards
Learn the basics
Key takeaways
- You supply liquidity and receive a share of the trading fees. That income is variable and not guaranteed.
- Impermanent loss is no side issue. If the price of one token diverges from the other, the pool can be worth less than if you had held the tokens, even after fees received.
- You can lose your entire deposit through a hack or fraud. There is no deposit guarantee.
- Anyone who is not sure they understand this is better off not starting, or only with an amount they can lose entirely.
Frequently asked questions
What is impermanent loss and can I avoid it? +
It is the difference between the value of your pool stake and the value of the tokens had you held them, because the pool rebalances your tokens when the price changes. You cannot avoid it entirely. With two stablecoins it is small, but they can lose their peg. Work it out in advance with IL = 2√r / (1 + r) − 1.
What income is realistic? +
That cannot be said. Income depends on trading volume, the size of the pool and rewards, and changes constantly. A high displayed APY often comes from reward tokens that can quickly lose value. Calculate after impermanent loss, costs and the price of the rewards, and assume a possible loss.
How do I check whether a protocol is trustworthy? +
You can never be completely sure. Look at age, audits by independent parties, past hacks and how the protocol is governed, and check links and contract addresses through official sources. Protocols with audits have been hacked too. Fully decentralised protocols usually have no supervisor, complaints body or deposit guarantee.
Origin
General technique