Liquidity Provision and LP Tokens
What is Liquidity Provision
Liquidity Provision is depositing assets into a DEX liquidity pool to enable trading and receiving trading fees in return. Liquidity providers are called LPs (Liquidity Providers).
In traditional finance, only professional institutions could be market makers. In DeFi, anyone with assets can become an LP. This is one of DeFi's core innovations.
The Liquidity Provision Process
Step 1: Select a Pool
Choose the token pair to deposit. Example: ETH-USDC, BTC-ETH
Considerations:
- Tokens you hold
- Expected fee income (trading volume)
- Impermanent loss risk (volatility)
- Pool stability (TVL, protocol reliability)
Step 2: Prepare Assets
Most AMMs require two tokens in equal value ratio.
Uniswap V2 example:
- To deposit $10,000 in ETH-USDC pool
- Need $5,000 worth of ETH + $5,000 USDC
Uniswap V3 (concentrated liquidity):
- Ratio can vary based on price range
- If current price is outside range, deposit only one token
Step 3: Add Liquidity
- Select "Pool" or "Liquidity" menu on DEX site
- Select token pair
- Enter amount to deposit
- (For V3) Set price range
- Approve tokens (first deposit)
- Approve "Add Liquidity" transaction
Step 4: Receive LP Tokens
When you add liquidity, you receive LP tokens. These represent your share in the pool.
The Role of LP Tokens
Proof of Share
LP tokens are proof of your share in the pool.
Example:
- Total pool TVL: $10,000,000
- My deposit: $100,000
- My share: 1%
- LP tokens: 1% of total issuance
Value Changes
LP token value changes based on:
Increase factors:
- Accumulated trading fees
- Underlying token price increases
Decrease factors:
- Underlying token price decreases
- Impermanent loss
Uses
LP tokens are valuable tokens themselves:
- Yield farming: Stake LP tokens for additional token rewards
- Collateral: Use as collateral on some lending protocols
- Sale: Sell LP tokens directly if needed (if liquidity exists)
Fee Income
Fee Structure
| DEX | Base Fee | LP Distribution |
|---|---|---|
| Uniswap V2 | 0.30% | 100% to LP |
| Uniswap V3 | 0.05%/0.30%/1.00% | 100% to LP |
| Curve | 0.04% | 50% LP, 50% veCRV |
| SushiSwap | 0.30% | 83% LP, 17% xSUSHI |
Yield Calculation
LP's annual yield (APR) is determined by:
APR = (Daily Fees × 365) / TVL × 100%
Example:
- Pool TVL: $10,000,000
- Daily trading volume: $5,000,000
- Fee rate: 0.30%
- Daily fees: $5,000,000 × 0.3% = $15,000
- APR = ($15,000 × 365) / $10,000,000 = 54.75%
Actual returns may differ:
- Trading volume fluctuates daily
- Impermanent loss can reduce actual returns
- Gas fees (on deposit/withdrawal)
Yield Tracking Tools
- APY.vision: Track LP positions, calculate actual returns
- DeFiLlama Yields: Compare APY by pool
- Revert Finance: Uniswap V3 analysis
Pool Selection Criteria
1. Trading Volume
High volume = High fee income
Pools with high volume relative to TVL have good capital efficiency. If daily volume/TVL ratio is 0.5 or higher, it's an active pool.
2. TVL
Appropriate TVL = Balance of stability and returns
- Too low TVL: Price manipulation risk, rug pull possibility
- Too high TVL: Intense competition, lower APR
3. Token Volatility
Low correlation = High impermanent loss
- Stablecoin pairs (USDC-USDT): Almost no IL
- Correlated asset pairs (ETH-stETH): Very low IL
- Uncorrelated pairs (ETH-UNI): IL risk exists
4. Protocol Reliability
Verified protocols = Lower smart contract risk
- Old and verified DEXs (Uniswap, Curve)
- Security audit status
- TVL duration
5. Additional Incentives
Some pools provide additional token rewards beyond trading fees.
- Protocol native tokens (UNI, SUSHI, etc.)
- Partner project tokens
- Points/airdrops
Caution: High incentive APR may not be sustainable. TVL often drops sharply and token prices fall when incentives end.
Uniswap V3 Concentrated Liquidity
Price Range Setting
In V3, you directly set the price range for providing liquidity.
Example: When ETH is $3,000
- Narrow range: $2,900-$3,100 (±3%)
- Wide range: $2,000-$4,000 (±33%)
- Full range: $0-∞ (same as V2)
Narrow vs Wide Range
| Category | Narrow Range | Wide Range |
|---|---|---|
| Capital efficiency | High | Low |
| Fee income | High (within range) | Low |
| Management needs | High | Low |
| Out-of-range risk | High | Low |
| Impermanent loss | Amplified | Mitigated |
When Out of Range
When price moves outside your set range:
- Liquidity becomes inactive
- You don't earn fees
- Position converts to single asset
Example: ETH-USDC, range $2,900-$3,100
- Price > $3,100: Position converts to 100% USDC
- Price < $2,900: Position converts to 100% ETH
When out of range, you need to remove liquidity and redeposit in a new range, incurring gas fees.
Strategies
Active Management:
- Pursue high returns with narrow range
- Reset range on price movements
- Requires time and gas fee investment
Passive Management:
- Low but stable returns with wide range
- No frequent management needed
- Similar experience to V2
Removing Liquidity
Withdrawal Process
- Go to "Pool" menu on DEX → "Remove Liquidity"
- Select removal ratio (25%, 50%, 100%, etc.)
- Approve transaction
- Receive both tokens + accumulated fees
Amount Received
Amount received at withdrawal may differ from deposit.
Example:
- At deposit: 1 ETH ($3,000) + 3,000 USDC = $6,000
- At withdrawal: 0.8 ETH ($4,000) + 4,800 USDC = $8,000
Token ratio changed with price movement, and fees accumulated to increase total value. However, if you had just held ETH, you would have $7,000 (1 ETH × $4,000 + 3,000 USDC). This difference is impermanent loss.
Withdrawal Timing
Good timing:
- When price is similar to deposit time (minimize IL)
- When sufficient fees have accumulated
- When better opportunities exist
Timing to avoid:
- Right after large price movements (realize IL)
- When gas fees are high
LP Risks
Impermanent Loss
The biggest risk. Covered in detail in the next article. You may lose compared to simply holding when prices change.
Smart Contract Risk
You can lose assets due to bugs in DEX or pool contracts. Mitigated by using verified protocols.
Rug Pull
Project teams drain liquidity and flee, especially in new/small token pools. Only LP in verified tokens.
Opportunity Cost
Assets locked in LP may miss other investment opportunities.
Summary
Liquidity provision is a core DeFi activity of depositing assets to DEXs and earning trading fees. LP tokens represent pool shares and can be utilized in various ways. When selecting pools, consider trading volume, TVL, token volatility, and protocol reliability. Uniswap V3's concentrated liquidity increases capital efficiency but requires active management. Understanding and managing impermanent loss is the core competency of an LP.
Next article: Complete Guide to Impermanent Loss - The Hidden Cost of LP