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Liquidity Provider is an investment that shares its stagnant digital assets in liquidity pools and earns money through it. These people are actually the liquidity providers for decentralized financial platforms to provide the necessary cryptocurrency for a pool.
Assets providing liquidity are locked into liquidity pools during a smart contract. In fact, these pools are a source of liquidity for the decentralized exchange. The process of sharing assets in liquidity pools represents the efforts of decentralized exchanges (DEX) to create a space for investors to conduct transactions directly.
Along with the increasing growth of liquidity pools, the profession of liquidity provider is one of the issues that digital currency users have shown great interest in. Even you yourself can be part of the liquidity provider. Thus, in the continuation of this article, I will discuss the concept of liquidity provider and other concepts related to it.
Liquidity Provider
Decentralized exchanges, or DEXs, focus on the participation of holders in pools of liquidity rather than specifying an entity to provide digital assets for transactions. Liquidity pools are actually smart contracts that allow users to receive assets. These users who send their assets to this smart contract are called Liquidity Provider or LP.
Liquidity pools are used as an important part of automatic market makers (AMMs) for digital currency loans, cryptocurrency exchanges, on-chain insurance and yield farming projects, etc.
Read more: Yield Farming or profit cultivation
Read more: Crypto Lending
A liquidity provider is, in simple terms, a person who provides the necessary liquidity for decentralized finance platforms by providing the required cryptocurrency of a pool.
In the liquidity process, both the liquidity required by the cryptocurrency market is provided and it also allows users to earn profits by depositing their cryptocurrencies in pools instead of holding digital currency or selling their assets.
Read more: What is digital currency holding or HODL?
When other users use the assets of these pools, the liquidity provider is given a percentage of the transaction fee. This type of earning is actually a passive income.
What is Liquidity Pool?
A liquidity pool is a smart contract that self-locks a collection of digital currencies used in decentralized finance platforms or DEXs. These pools are actually a way to provide necessary liquidity for DEXs. The Matching Engine is a system that matches orders with each other, which are considered as an important part of the centralized exchange (CEX) along with the order book.
This method is suitable for facilitating transactions in centralized exchanges and creating complex transactions. But DeFi platforms are not able to do this method; Because trading in these protocols is done on the chain and all transaction information is stored in a blockchain network without the supervision of a central organization.
In this situation, the main problem is that, for example, if the activity of an exchange is based on the Ethereum blockchain order book, more gas must be paid to create an order or cancel it, which will also increase the cost of the transaction.
On the other hand, the liquidity provider will no longer receive enough profit through liquidity provision. Blockchain networks will also not have the necessary power to carry out billion dollar daily transactions of digital currencies in terms of throughput.
In this case, liquidity pools can be considered as a suitable alternative to the order book. These pools are used by decentralized exchanges that operate based on the system of Automated Market Makers (AMMs). One of the goals of this method is to execute transactions with high liquidity and low slippage.
Does a liquidity provider have stable income?
Decentralized financial platforms, or DEXs, charge a fee to the trader in exchange for providing liquidity. A part of this received fee is given to the investors who have shared their digital assets in the pools. In fact, based on this, the liquidity provider creates a continuous income for himself by sharing his assets in the pools. But the dangers of this process cannot be neglected.
Liquidity Provider performance
As I mentioned above, people who send their assets to liquidity pools are called liquidity providers. In other words, these people provide the necessary liquidity for decentralized platforms by providing the digital currency needed for a pool. Providing liquidity simultaneously has two benefits, which are mentioned below:
- Making a profit for the liquidity provider due to holding their assets in the pool instead of selling them
- Providing the required liquidity for the cryptocurrency market
The role of the liquidity provider in the liquidity pool
As mentioned, automated market makers or AMMs allow on-chain transactions without the need for an order book. Considering that there is no need for a third party to do this; Traders will be able to open positions for trading currency pairs that may not have the necessary liquidity in order book-based exchanges.
In this situation, instead of dealing with a third party, you will be dealing with the liquidity of the pool during the trade. This means that unlike the order book or order books, buyers will not need sellers and sellers will not need buyers. Rather, in this situation, only the availability of trading currency pairs that you intend to trade in the pool is sufficient.
Usually, to participate in the liquidity pool, it is necessary to have a currency pair that is equivalent in terms of value. For example, if you intend to participate in a USDC and ETH pool as a liquidity provider, you must send an equal amount of USDC and Ether to this pool. If we consider the price of each Ether to be 2,000, you will be required to deposit one Ether and 2,000 USDC into this pool.
What is a liquidity token?
The liquidity provider provides liquidity to pools using its digital assets for the necessary efficiency of various types of automatic market makers such as Curve, Uniswap, etc. When digital assets are deposited in cryptocurrency pools, automatic market makers automatically provide a new token to the liquidity provider on behalf of the depositor’s share in the pool, which is called a new token, liquidity provider token or (Liquidity Provider Token).
This liquidity token can be used both on the native platform and in other decentralized applications.
LP Tokens cause automated market makers to remain non-custodial. With LP tokens, you have the possibility to control your own assets instead of being controlled by human operators and using smart contracts.
Also, the value of LP Tokens is calculated based on your share of the pool. For example, if you have deposited $10 in a balancer pool with a total value of $100, you will receive 10% of the pool’s LP tokens. Because you have provided 10% of the liquidity of the pool.
The method of calculating the profit of the liquidity provider
Due to the fact that the liquidity providers have a share in the pool, their profit is also obtained based on this share. Of course, it is noteworthy that different platforms calculate the income from transactions in different ways. For example, in the Quick Swap exchange, 0.3% of the total amount is deducted as a fee by making a transaction; 0.25% of it belongs to Liquidity Provider.
What is the use of LP Token?
Constant changes are one of the characteristics of decentralized financial platforms. Along with these changes, the related terms are also changed. For example, in the balancer protocol, what we refer to as LP Token is called BPT.
LP token holders can participate in a pool with their assets. Tokens will also represent their assets. Another use of LP tokens is their function in yield farming. In fact, maximizing income by depositing tokens in DeFi programs is the main idea of Yield Farming. This profit maximization is created by moving tokens and withdrawing them in protocols.
To better understand this issue, below I refer to the CRV token farming steps in the Crow protocol:
- Depositing currency pairs in the Crow pool
- LP token pool tracking
- Making LP deposits in the staking pool
- Access to the Kro token
The liquidity provider receives interest twice during these stages; First by transaction fee income and then by partnership in yield farming.
The most popular liquidity provision platforms
With the implementation of liquidity pools, a large number of liquidity provision platforms were recognized. I mention some of them below:
Uniswap
UniSwap platform is one of the best decentralized exchanges. One of the features of this platform is the variable interest of Liquidity Provider for pools, the highest of which is 0.3%.
Sushi Swap
This platform is one of the forks of UniSwap and offers 0.25% of the transaction fee to the Liquidity Provider of its pools.
Pancake Swap
The Pancake Swap platform is based on the Binance smart network. The transaction fee in Pancake Swap is 0.25%, of which 0.17% belongs to the liquidity provider and 0.3% to the pool builders. This platform is the possibility of depositing LPs by the liquidity provider in the CAKE Farms service.
Curve Finance
The fee for all pools on the decentralized exchange platform of Crofinance is equal to 0.4%, half of which is considered as the Liquidity Provider’s income.
Risks of partnership in Liquidity Provider
Below I mention the risks and risks of participating in Liquidity Provider:
Unsustainable loss
One of the biggest risks for liquidity providers is unsustainable losses. This risk occurs when there is a large difference between the price of the deposit asset compared to the time of deposit;
In this case, the possibility of unstable loss will increase with the increase of difference. The cause of sustained loss is related to the type of activity of automatic market makers. In fact, in the system of these market makers, the value of each trading pair should be equal.
Smart contract
As I mentioned above, when you deposit into pools, your assets are actually stored in a smart contract. In this case, there is no intermediary to maintain the property; But since your capital has a programming code, if there is any problem in the code, there will be a possibility of capital loss.
By sharing their stagnant assets in pools, liquidity providers can receive a portion of the fees that exchanges charge traders for using liquidity resources.
Yes. Unstable loss is one of the biggest liquidity supply risks in the field of DeFi.
