Liquidity pools are a cornerstone of decentralised finance (DeFi). Without them, seamless trading and the steady functioning of protocols would be impossible. For liquidity providers, understanding the associated risks and opportunities is critical.
Grigory Osipov, director of investigations at Shard, explained where to start, how not to lose your initial capital and how to avoid enriching fraudsters, in comments to ForkLog.
Key risks
Impermanent-loss risk
Such losses arise when the prices of tokens in a pool move relative to each other, which can leave you worse off than simply holding the assets. It is akin to Russians taking out “cheap foreign-currency mortgages”, only for the rouble to plunge. To mitigate this, provide liquidity only with assets from your long-term portfolio and favour highly correlated pairs such as BTC and ETH.
On some DeFi platforms users can input the amount of tokens they plan to deposit and receive a calculated estimate of impermanent loss (IL).
Consider a case where liquidity providers (LPs) place 50% ETH and 50% UNI on Uniswap. If the price of Ethereum rises, that creates an arbitrage opportunity to profit at LPs’ expense.
Suppose ETH gains 5%. Arbitrageurs can then buy ETH on Uniswap at a 5% discount to the external market. The decentralised exchange (DEX) will reward them for selling UNI for ETH until the token ratio equilibrates. LPs will end up losing part of the assets they deposited in the pool.
Smart-contract exploit risk
DeFi platforms run on automated, self-executing smart contracts whose code may contain vulnerabilities. If hackers find them, they can steal funds and drain pools. By our count, in 2024 DeFi services ranked second only to crypto exchanges by number of hacks. In total they lost crypto equivalent to ~$474m.
Volatility
Sharp price swings can both boost and depress LP returns, while adding risk to capital. For example, if a pool has only $10,000 locked, selling $1,000 worth of tokens can move the price by almost 10%.
Counterparty risk
There is a risk of interacting with a sanctioned counterparty or with illicitly obtained cryptoassets. Participating in pools on unreliable or unvetted platforms can lead to losses due to fraud or bankruptcy. Many DeFi products and services lack proper checks, creating serious risks tied to non-compliance with AML.
Price-manipulation risk
In DeFi, markets are vulnerable to manipulation by whales with sufficient capital to move prices by generating false signals for liquidity and LPs. This can affect pricing and result in impermanent loss. One example was Kaspa (KAS): in the second half of 2024 it lost 30% of its value.
Analyst Csm19XD suggested Kaspa’s price was being manipulated. Charts showed a persistent downtrend in KAS. On 25 October 2024, positions worth $800,000 were liquidated on Binance, ByBit and Huobi, alongside a 35% drop in open interest. This pointed to possible controlled manipulation by whales who strategically opened shorts to trigger panic selling by smaller traders.
Centralisation risk
Key decisions about a DeFi platform’s operation are sometimes taken by a small circle with admin rights. They may abuse this power—for instance, by draining or manipulating liquidity pools for personal gain. This creates material risks for LPs and users, who may lose access to funds or face unpredictable protocol changes.
Irreversibility of transactions
Unlike traditional finance, where transactions can be challenged or reversed, DeFi operations are final. In the event of error, fraud or unauthorised access, users cannot recover funds. This heightens capital-loss risk, especially if a smart contract contains vulnerabilities or a user makes a mistake when interacting with a platform.
Low-liquidity risk
Thin liquidity can be a major risk for both traders and LPs. Users may face slippage—the gap between the expected and executed price. That leads to less favourable trades, especially on DEXs where liquidity is confined to specific pools. For LPs, low liquidity means fewer fees, hurting returns. It can also be hard to buy or sell at desired prices, reducing flexibility and increasing market risk.
If the price moves sharply while funds are being withdrawn, a user may end up with a lower total value than if they had simply held the assets.
How to assess potential returns
LPs are typically rewarded via trading fees and various incentives such as governance-token distributions. These measures aim to attract and retain liquidity providers by motivating active participation.
The first metric to weigh is fee income. On most DEXs (Uniswap, SushiSwap, Curve), LPs receive a share of each trade’s fee (typically 0.3% on Uniswap v2, 0.05–1% on Uniswap v3). The higher the pool’s trading volume, the higher the potential income.
Suppose a user supplies $1,000 to an exchange ($500 in BTC and $500 in ETH at current rates). The pool holds $100,000 in total, so the user’s share is 1%. Assume daily BTC–ETH swaps total $1m and the fee per swap is 0.3%. The pool’s total fee intake is $3,000 (0.3% of $1m), of which the user’s 1% share is $30.
The second important metric is token incentives. Some platforms offer additional rewards in native tokens to attract liquidity. In decentralised lending protocols such as Compound and Aave, LPs receive a proportional share of interest paid by borrowers and, in some cases, extra governance tokens.
Third, do not forget to factor in gas costs. They can materially erode profits, especially during network congestion. Two notions determine the total cost: gas limit and gas price. Fees vary with network load and the urgency or importance of a transaction.
Each time traders transact through a pool, a fee is charged and distributed to LPs in proportion to their share. Fees vary by platform and pair. A pool grows continuously by taking a cut of every trade. Swap fees are added to the pool, increasing its total liquidity.
To mitigate impermanent loss:
- participate in pools with sufficient depth, and diversify across platforms to reduce overall risk;
- use venues with IL-compensation mechanisms (for example, Bancor, Balancer);
- allocate to pools with higher trading volumes, where fees can offset losses.
To manage asset-depreciation risk properly, diversify across pools and positions; analyse projects before entering (tokenomics, team, smart-contract audits); and use DeFi hedges (options, futures, cover from Nexus Mutual). Participating in multiple pools on different platforms reduces aggregate risk.
To guard against smart-contract exploits, continuously monitor security practices. Choose platforms with vetted contracts and security audits (Uniswap, Aave, Curve). Track a venue’s reputation and operational history. Spread liquidity across protocols to minimise damage.
One well-known exploit was the attack on the Nomad cross-chain bridge. A bug in the smart contract cost Nomad nearly $200m and enabled what experts called “the first decentralised mass robbery in history”.
Effective liquidity management requires monitoring current and forecast short-term liquidity via a payments calendar, and tracking liquidity structure by regularly compiling maturity-gap reports for assets and liabilities.
To optimise liquidity-risk management, it is prudent to manage current and structural liquidity separately (the ability to meet obligations with maturities of up to 30 days).
Liquidity-risk management also rests on analysing planned cash flows, adjusting timing and amounts of inflows and outflows for identified risks. This helps LPs not only minimise losses but also improve efficiency.
How to choose a platform
When selecting a DeFi platform, first analyse the fees charged for token swaps and for adding or withdrawing liquidity. They directly affect your returns. Some platforms levy extra charges on providers, such as deposit fees.
Assess how stable the platform’s returns are. They can fluctuate materially with user activity and market conditions.
Determine liquidity depth and trading volumes. These signal community trust. High-volume venues (Uniswap, Curve, Balancer) tend to deliver more stable income. Gauge how quickly you can withdraw liquidity without heavy losses. Stable pairs and low-volatility pairs (for example, stablecoins) reduce impermanent-loss risk.
Suppose a user creates a WBTC/USDT pool on a new DEX by depositing 1 WBTC and 20,000 USDT. Bitcoin then rallies quickly to 25,000 USDT. Arbitrageurs, spotting a pricing gap on the new exchange, buy wrapped bitcoin from the pool until the price reaches parity with the broader market.
As a result, USDT dominates the pool and WBTC is nearly exhausted. Initial deposit: 20,000 USDT plus 1 WBTC. Since funds are added in equal parts on the DEX, the total value of pool assets is equivalent to 40,000 USDT. After bitcoin’s rally to 25,000 USDT, the pool’s liquidity should be worth 45,000 USDT. But with WBTC depleted, the pool holds 40,000 USDT and 0 BTC. The opportunity cost is 5,000 USDT.
Understand how fees are structured—this affects potential income. It is also important to grasp all platform-related costs. Periodically recalculate returns net of fees, rewards and IL, and reassess your strategy. There are IL calculators from dailydefi.org and CoinGecko.
Before providing liquidity, make sure the platform has undergone an independent security audit. This reduces the risk of hacks, vulnerabilities and potential failures.
It is worth recalling the hack of the centralised finance protocol Convergence. The company confirmed its system was breached on 1 August 2024 via a smart-contract exploit. The attacker manipulated the creation and sale of the protocol’s internal token for $210m and also stole $2,000 in staking rewards.
It is important to choose a platform with a solid reputation and a large community. Venues with active users, a transparent track record and positive feedback appear more stable and are more likely to pay compensation in a force majeure.
Ensure the platform has an intuitive interface for adding liquidity, tracking returns and withdrawing funds. Check compatibility with popular wallets such as MetaMask, Ledger or Trezor to ease interaction.
If a platform operates across several blockchains (for example, Ethereum, Binance Smart Chain, Polygon), it can increase your flexibility in choosing where and how to provide liquidity.
Conclusions
Liquidity providers face a multitude of risks and opportunities that demand careful analysis and a strategic approach. In a fast-changing financial market, it is vital to weigh potential threats such as asset volatility and competition against opportunities including rising DeFi demand and new technologies.
Making informed decisions grounded in a deep understanding of these factors allows LPs not only to minimise risk but also to exploit emerging openings for sustainable growth and competitive advantage. Ultimately, the right strategy blends innovation with robust risk management—key to long-term success in this dynamic field.