Liquidity Pooling 101. Liquidity Pools are the foundation of Uniswap. For Uniswap to exist and swapping between ETH<>Tokens and Tokens<>Tokens active, there needs first to be a pool of the crypto assets in a Liquidity Pool. There are two major participants in Uniswap and similar DEXs: Liquidity Providers, and Traders/Swappers. Liquidity Providers are rewarded fees for providing liquidity, while Traders pay those fees with each swap transaction
The way the pools work is you have to deposit an equal value of ETH and the token that you want to participate with. If you want to participate in the PAR liquidity pool, you have to have the equivalent amount of PAR and ETH to contribute all at the same time. This equal amount is simple based on the current ratio in the pool of PAR / ETH, and can be easily verified by looking at the uniswap exchange PAR/ETH contract. Liquidity Pools can also be established with Token<>Token, such as a DAI/USDC or PAR/USDC pool.
When a trader wants to swap PAR to ETH on Uniswap, your liquidity is tapped into. You are the grease that lets the swap gears spin and work, along with all of the other combined liquidity providers in the pool. When a trader swaps ETH to PAR, effectively there is new ETH put into the pool and the same equivalent amount of PAR pulled out of the pool. This means that the ratio in the pool of ETH / PAR changes with every swap. So, the amount that you put in may shift more towards Ethereum, or it may shift more towards PAR based on the trade that needs to happen. With the opposite swap, PAR is put in and Ethereum removed; thus your Ethereum pooled liquidity would slightly shrink, and your PAR liquidity will slightly increase. Your Pool liquidity is always represented by the % ownership you have in the pool times the current ratio of tokens in the Pool (ie ETH : PAR). The important part is that your Principal is always maintained in terms of equivalent value of both assets, so even if your pooled ETH balance goes up while your PAR balance goes down, the equivalent value in the ETH : PAR you started with is still the same; ie if you were to cash both out to ETH or both to PAR on day 0 or day 10, you would have the same ending balance.
So why would you want to provide Liquidity?
Liquidity providers accrue fees from all of the swap trades. There’s a 0.3% swap fee that Uniswap charges to the swapper that is then split among all the liquidity providers in that specific pool based on how much of the pool they’re offering. Essentially, when a trader makes a swap, they leave behind 0.3% of their trade in the pool - and since you are entitled to your % ownership in the pool, you now have that pro-rata claim to the fee. If it’s a large amount that you’re offering in a liquidity pool, a large percentage of the pool, you’re going to get a bigger chunk of that 0.3%. Given there is no change in liquidity providers actions (ie no adds or removes), a liquidity pool will naturally increase in size overtime simply by the fees accrued, and in this example your relative size of the slice doesn’t change, but the whole pie gets bigger and bigger and so actual slice of the pie (ie liquidity investment) gets bigger! The advantage is that your principal effectively cannot get eroded, unlike simply holding one currency over another, and you still can earn yields from accruing fees from swappers.
Impermanent Loss: There is, however, the risk that as a liquidity provider you don’t end up with the same balance of ETH / PAR after several days or over time. Even though your total value is the same, you may lose out on some of the upside of PAR or ETH depending on the shift in price in the pool. This shift is coined Impermanent Loss, because there is no real loss to your total value of digital assets, but the mix has changed that you own and that composition “could” have been worth more if you had simply held them both separately out of the pool.