Yield Farming and Liquidity Pools

Yield Farming & Liquidity Pools

Where LP yield comes from (fees, incentives), impermanent loss, pool types, and a practical checklist to avoid common pitfalls.

TL;DR: LP yield = trading fees + optional token incentives –  impermanent/divergence loss − gas & management costs.
Stable/pegged pairs minimize IL. Concentrated-liquidity (CLMM) boosts fee density but adds range risk and upkeep.

1) Where Yield Comes From

  • Trading fees: Every swap pays a fee (e.g., 0.01–1%) that’s distributed to LPs pro-rata. More volume in your active price range → more fees.
  • Token incentives: Protocols add rewards to bootstrap liquidity. These can materially boost APR, but they are variable and may end abruptly.

Core identity of an LP: You’re a market maker. Your P&L is fees + incentives minus the cost of providing inventory (divergence/IL) and operations.

2) AMM 101: Pool Types & Fees

  • x·y = k (constant product): General-purpose (e.g., UNI-style). Wide price support; higher IL when prices diverge.
  • Stable/curve pools: Tailored for correlated assets (e.g., USDC/DAI, stETH/ETH). Lower slippage near peg → higher capital efficiency and typically lower IL.
  • Fee tiers: Choose a tier that matches expected volatility. Correlated pairs fit low fees; volatile pairs may justify higher fees to offset IL.

3) Impermanent Loss (IL) & Quick Examples

As price moves, the AMM rebalances your inventory. Versus just holding the two assets, you may end up with less total value if prices diverge.

Approx. IL for constant-product AMM given price ratio r = P_new / P_old:
IL ≈ 2·√r / (1 + r) − 1     (negative except at r = 1)
Examples:
 r = 1.5  →  ~−2.0%
 r = 2.0  →  ~−5.7%
 r = 3.0  →  ~−13.4%
Rule of thumb: IL grows with volatility and time spent out of range. Stable/pegged pairs (or LSD/LST vs ETH) generally suffer much less IL.

Terminology: Many dashboards call it “impermanent loss,” but once you withdraw or rebalance, it’s realized as divergence loss. The antidote is fee income. if fees > loss, LPing can beat HODLing.

4) Concentrated-Liquidity (CLMM) Considerations

  • Higher fee density: Placing liquidity in a narrow range boosts fees when trades happen inside your band.
  • Range risk: If price exits your range, you earn zero fees and sit 100% in one asset until you rebalance.
  • Upkeep & gas: Narrow bands require more active management (especially volatile pairs). On L1 this can eat your edge; L2s are cheaper.
  • Hedging: Some pros hedge with perps/options to neutralize directional risk, but this adds complexity, funding costs, and liquidation risk.

5) Farming Incentives & Emissions

  • APR composition: Separate fee APR (organic) from emissions APR (subsidy). Sustainable yields rely more on the former.
  • Schedules & locks: Check reward halving dates, vesting/locking, and gauge votes. When subsidies drop, APRs can collapse and LP capital migrates.
  • Sell pressure: Farmers often sell rewards → downward pressure on the reward token unless there’s real demand/sink.

6) Ops: Compounding, Gas, Auto-Compounders

  • Compounding: Reinvest fees/rewards to boost APY. Batch actions; prefer L2s for frequency. Always compare added gas vs uplift.
  • Auto-compounders: Save time but add smart-contract risk and performance fees. Vet audits, TVL caps, upgrade keys, and pause mechanisms.
  • Net P&L view: Net = Fees + Incentives − Divergence/IL − Gas − Rebalance costs. Track all components, not just headline APR.

7) LP Checklist (pre-deposit)

  • Pool fit: Is the pair stable/correlated (good for low fees) or volatile (needs higher fees/wider ranges)?
  • Depth & turnover: Check TVL and volume/TVL. Healthy utilization (e.g., 10–30%/day for stables) indicates fee potential.
  • Contract risk: Audits, time-tested AMM, upgrade/admin keys, and clear incident runbooks.
  • Incentive durability: When do rewards end? What remains as pure fee APR?
  • Ops plan: Range width, rebalance triggers, gas budget, and exit plan if volatility spikes.

Quick check

  1. Name the two main sources of LP yield.
  2. When does impermanent loss occur, and what offsets it?
  3. What’s a key downside of very narrow CLMM ranges?
  4. Why separate fee APR from emissions APR?
Show answers
  • Trading fees and token incentives.
  • When prices diverge versus HODLing; fee income can offset it.
  • Out-of-range positions earn no fees until rebalanced, adding upkeep costs.
  • Fees are organic/sustainable; emissions are temporary subsidies that can vanish.

Go deeper

  • Uniswap Docs — AMM math, v3 CLMM, fee tiers.
  • Curve Docs — stable curves, pegged assets, gauge incentives.

Next: understand stablecoins, pegs, and the risks behind them.

Next: Stablecoins →