Liquidity Pools and Staking: What the APY Number on the Homepage Isn't Telling You
How liquidity pools and staking really work, with a worked impermanent loss example most platforms never show you.
By Firoz Khan|15 July 2026|Updated 20 September 2026|10 min read
DeFi platforms lead with a headline APY because a big number sells. What they don't lead with is where that yield actually comes from, what happens to your capital if the tokens you deposited move against each other, or what a smart contract exploit does to funds that were never in a bank in the first place. Liquidity pools and staking are genuinely different mechanisms with genuinely different risks, and conflating them, which the marketing often does, is how people end up in a position they didn't understand they were taking.
What a liquidity pool actually is
A liquidity pool is a shared pot of two (or more) tokens that traders swap against directly, without a traditional order book or a counterparty on the other side of the trade. You deposit an equal value of both tokens, receive a share of the pool represented by a token, and earn a cut of the trading fees generated by swaps that route through it. You're not lending your tokens to a borrower in the way a savings account works, you're providing the inventory that makes decentralised trading possible, and you're paid a fee for taking on the risk that comes with that.
Impermanent loss, worked through with real numbers
Say you deposit £5,000 of ETH and £5,000 of a stablecoin into a pool, £10,000 total, when ETH is priced at £2,000. If ETH then doubles to £4,000 outside the pool, arbitrage traders rebalance the pool until your share is worth roughly £11,600 rather than the £15,000 you'd have if you'd simply held the ETH and stablecoin separately. That £3,400 gap is impermanent loss: the pool's automatic rebalancing means you end up holding less of the asset that went up and more of the one that didn't, compared to just holding both. It's called 'impermanent' because it can shrink if prices move back, but if you withdraw while the prices have diverged, that loss is fully realised and permanent for you. Fee income can offset it over time, but for volatile pairs it very often doesn't.
Staking is a different mechanism entirely
Staking means locking tokens to help secure a proof-of-stake blockchain, validating transactions in exchange for newly issued tokens or a share of network fees. There's no impermanent loss because you're not pairing two assets, but you are taking on the underlying asset's price risk plus, in most cases, a lock-up period during which you can't sell, plus 'slashing' risk on some networks where misbehaviour by the validator you've delegated to can cost you a portion of your stake. Staking yield is real and mechanically explainable, it comes from network issuance and transaction fees, which is why it tends to be single or low double digits rather than the eye-catching numbers seen elsewhere.
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Smart contract risk is not a footnote
Every dollar deposited into a DeFi protocol sits inside code, and that code has, repeatedly and across the industry, contained bugs that let attackers drain pools entirely. Auditing reduces this risk, it doesn't eliminate it: audited protocols have still been exploited. There is no deposit protection scheme behind any of this, no FSCS, no ombudsman, and if a contract is exploited the funds are typically gone. This risk exists on top of, not instead of, the market risk from the tokens themselves, and it's rarely mentioned anywhere near the APY figure.
Lock-ups turn a market move into a forced loss
Many staking and yield products lock your tokens for a set period, sometimes days, sometimes months. If the token price falls sharply while your funds are locked, you cannot exit early to limit the damage, you simply watch it happen. Some protocols offer 'liquid staking' derivatives that let you trade your position while still locked, but that introduces yet another layer, a derivative token that can itself de-peg from the underlying asset under stress, which is exactly what it's meant to protect you from.
Reading an APY number properly
A headline APY on a new or small protocol is very often subsidised by the platform's own token emissions, paid to attract deposits rather than generated by genuine trading or lending activity. That kind of yield tends to fall sharply once emissions taper or the token used to pay it loses value, sometimes both at once. Ask three questions before depositing: where does this yield actually come from, is it paid in the same asset I deposited or a separate token I'll then need to sell, and does the number include or exclude impermanent loss and price risk. Real, sustainable yield in DeFi is almost always a smaller, less exciting number than the one on the homepage.
Where people get this wrong
The recurring mistake is comparing a DeFi APY directly against a savings account rate as though they carry equivalent risk, when they don't come close. A 20% APY liquidity pool and a 4% savings account aren't two versions of the same product, one is insured cash and the other is an uninsured, code-dependent position with two overlapping sources of loss on top of the headline number. Before depositing anything, work out the impermanent loss scenario for a large move in either direction using the platform's own numbers, check whether the protocol has been audited and by whom, and size the position as though the smart contract risk alone could take it to zero, because on any given protocol, it genuinely can.
A reminder
The FCA risk warning still applies to higher-risk crypto content. Always assess how much risk you are willing to take before buying.
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