Liquidity Provider: What Is a Liquidity Provider in the World of Crypto
By | Updated January 7th, 2022
What is a liquidity provider?
A liquidity provider is a decentralized exchange (DEX) user who funds a liquidity pool with different tokens. These tokens facilitate fast trading by other users. The liquidity provider receives income for letting others use their tokens.
Why Are Liquidity Providers Necessary?
Traditional markets which deal in stocks, bonds and currencies often operate according to an order book model. This model tracks buy orders, sell orders and order history.
The order book model thus creates a system in which buyers announce the maximum they will pay for a commodity, as well as the minimum price sellers will sell said commodity for.
A market that utilizes the order book model requires liquidity in order to function. Liquidity is necessary to cover any disparity in the bid-ask spread, and it is traditionally supplied by market makers who volunteer to always buy or sell a certain asset.
This enables a market user to trade without waiting for a willing counterparty to step forward.
But a DEX operates too differently from a traditional market for a conventional market maker to serve any useful purpose. No market maker can keep track of a market that may easily record around 30,000 transactions per hour.
Even if they could, they would probably go broke from gas fees within minutes.
In addition to failing to execute trades, the slow speed of traditional market makers would also cause slippage (where traders are forced to settle on prices they hadn’t agreed to due to movement in price between the time of the order and the time the trade can finally be executed).
A DEX gets around this limitation by utilizing an automated market maker (AAM) – essentially a robot that does away with the need for market makers but which still needs liquidity to function.
How Do Liquidity Providers Work?
A liquidity provider volunteers to create or contribute to a liquidity pool: a collection of two tokens that are locked in a smart contract, and which permits other DEX users to trade illiquid trading pairs without need for intervention by a traditional market maker.
So long as the liquidity pool they contribute to is large enough, a liquidity provider can facilitate trades of any size or volume.
In essence, a liquidity provider provides two equal values of two tokens to a liquidity pool. That way whenever a trade between token A and token B is executed, the tokens requisite for said trade to execute immediately are already available to the trader.
Because the liquidity pool and the AAM which utilizes it are always present, the liquidity provider further serves to prevent slippage.
The liquidity provider does not do all of this out of the goodness of their own heart. Depending on the amount of liquidity they contribute to a given pool, they are assigned a certain value of LP tokens. When a liquidity pool is used, a 0.3% fee is distributed among that pool’s providers in proportion to their contributions to it.
When the liquidity provider retrieves their liquidity, they burn their accumulated LP tokens to receive the profits they have accrued in consideration of letting others utilize their wealth.
A liquidity provider contributes the tokens requisite for high-volume DEX trading, where a traditional market maker’s intervention would be too slow to be practical. The liquidity provider’s tokens sit in a liquidity pool, where they may always be utilized to facilitate a trade between other DEX users.
In exchange for their contribution, the liquidity provider receives passive income in the form of LP tokens.