Why don’t you make money as a liquidity provider (LP)?

introduction

Many users entered DeFi and invested money excitedly after seeing the high APY (annualized rate of return) of liquidity mining. However, after a few months, not only did they not make any money, but their principal was even reduced.

Why is your liquidity pledge not profitable? Today, we thoroughly analyze the real reasons why LPs are not profitable from five perspectives: impermanent loss, fee income, token depreciation, liquidity pool structure, and market manipulation , and provide solutions.

Impermanent Loss: LP’s Biggest Enemy

What is impermanent loss?

When you provide liquidity to an AMM (Automated Market Maker), your funds are deposited in two tokens (such as ETH/USDC) in a 50/50 ratio. If the price of one of the tokens fluctuates drastically, the value of your asset portfolio will be lower than if you simply held both tokens. This is impermanent loss .

AMM calculation rules (X*Y=k)

Suppose you originally have an Ethereum worth 2000U. If the price of ETH rises to 4000 USDC

If you do not provide liquidity and simply hold:
- Your 1 ETH is now worth 4000 USDC, plus the original 1000 USDC.
- Total value = 4000 + 1000 = 5000 USDC.
But if you are an LP, the pool will automatically adjust the price:
- According to the rule, ETH × USDC = 1000 , and the new price requires USDC/ETH = 4000 , so:
  - We get an equation system X*Y=1000, Y/X=4000
  - New ETH amount = √(100 / 400) = 0.5 ETH
  - New USDC amount = √(100 × 400) = 200 USDC
- Your liquidity is now worth: 0.5 ETH × 400 + 200 USDC = 400 USDC.

Case calculation

You deposit **1 ETH (2000) + 2000 USDC∗∗ (total value 2000) + 2000 USDC ∗∗ (total value 4000).
If ETH rises to 4000, your pool will automatically adjust and may eventually become 0.707 ETH + 2828 USDC ≈ 5656.

(According to the AMM automatic market making algorithm. 4000≈2828/0.7)

But if you simply hold 1 ETH + 2000 USDC , your total value is $6000 .
Impermanent loss = 6000−6000−5656 = $344 (about 5.7%)

Conclusion : The greater the price fluctuation of the currency, the more serious the impermanent loss will be, and it may even swallow up all the transaction fee income.

Low Fee Income: LP’s Real Income is Overestimated

Many DeFi projects advertise “super high APY” , but the actual return may be far lower than expected. The reasons include:

(1) Insufficient trading volume

If the liquidity pool has low trading volume, the fee income will also be low.
For example, for a pool with a TVL (total locked value) of 10M, if the daily trading volume is only 10M , and for a pool with a daily trading volume of only 1M, the handling fee (0.3%) is only $3000 per day. After being distributed to all LPs, the profit is negligible.

(2) Devaluation of mining coin rewards

Many projects use governance tokens (such as UNI, CAKE) to incentivize LPs, but these tokens may continue to fall.
For example, the APY of a pool shows 100%, but 80% of it is project tokens. If the token price is halved, the actual return may be only 20%.

Token depreciation: Risk of LP’s principal shrinking

(1) The staked token itself falls in value

If you provide ETH/BTC liquidity, but ETH plummets 50%, even if the fee income is good, your principal will still shrink significantly.
LP ≠ HODL (long-term holding) . When the market falls, LP may lose more than simply holding.

(2) High risk of junk coin liquidity pool

Many new projects use high APY to attract LPs, but the tokens may return to zero (such as MEME coin and Dogecoin).
For example, a "Dogecoin copycat" pool had an APY of 1000%, but the token fell 90% in a week, and the LP lost all its money.

Liquidity pool structure issues: CLMM vs. traditional AMM

(1) Traditional AMM (such as Uniswap V2)

Funds are evenly distributed across all price ranges, with higher impermanent losses.
Suitable for stablecoin pairs (such as USDC/USDT) , but not suitable for highly volatile assets.

(2) Centralized Liquidity AMM (CLMM, such as Uniswap V3)

LP can customize the price range (such as ETH providing liquidity between 1800−1800−2200).
Risk : If the price goes outside the range, LP’s funds will become a single asset and may miss out on the rise or suffer a larger decline.

Examples :

You provide ETH liquidity at 1800−1800−2200, but ETH rises to $2500, and all your funds are converted into USDC, and you miss out on the rising profits.

Market manipulation: Targeting LP’s “scientists”

(1) Sandwich Attack

The robot detects your large transaction, buys first to push up the price, allowing you to complete the transaction at a higher price, and then sells it immediately to make a profit.
Result : Your trading slippage increases and LP profits are sucked away by the robot.

(2) Liquidity Drain

The sudden withdrawal of liquidity by large funds resulted in insufficient pool depth, sharp price fluctuations, and LPs incurring additional losses.