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What Is a Liquidity Provider in Cryptocurrency?

What Is a Liquidity Provider in Cryptocurrency?

Liquidity Providers are how decentralised exchanges or DEXs allow people to trade without an intermediary. Instead of having a large central entity providing all of the digital assets for trading, DEXs rely on individuals and institutions to provide their own cryptocurrencies to a common pool, with which others may trade. These providers are called Liquidity Providers, sometimes abbreviated as LPs.

In this Learn Crypto article, we’ll discuss and learn:

  • What does a Liquidity Provider do? 
  • Can you make money from becoming a Liquidity Provider?
  • What are Liquidity Provider tokens or LP tokens?
  • Popular DEXs for Liquidity Providers

What does a Liquidity Provider do?

As a starting point, liquidity in cryptocurrency markets technically references how easy it is to trade digital assets at an exchange. The more liquidity the exchange has, the easier it is to trade. In this way, an exchange with high or deep liquidity means that the exchange can easily handle trading requests of large volumes.

In practice, simply having a large amount of cryptocurrencies at the exchange’s disposal ensures it has a high level of liquidity.

In decentralised finance or DEFI, there are no central entities that control large amounts of crypto. There are several ways that DEXs provide liquidity, and this article will discuss DEXs that use the automated market maker (AMM) model.

To learn more about this particular type of decentralised exchange (DEX) and how it works differently from a centralised exchange (CEX), read this Learn Crypto article: “What are Decentralized Crypto Exchanges? DEX Explained.” 

AMM types of DEXs like Uniswap, SushiSwap and Pancakeswap. As the name suggests, a liquidity provider simply provides liquidity to these types of DEXs. They do this by providing their own cryptocurrency to a common pool, which is then available for anyone to interact with to trade or swap tokens.

This pool is called a Liquidity Pool. It typically is made out of a pair of different digital assets, and can only swap in or swap out those assets. For example, an ETH-USDT Liquidity Pool lets you swap ETH for USDT, and vice versa.

Liquidity Providers must provide both assets in the pair, in equal value. For example, to contribute $100 worth of liquidity to an ETH-USDT Liquidity Pool, you must provide $50 worth of Ether (ETH) and $50 worth of USDT.

Is it safe to make money from becoming a Liquidity Provider?

The short answer is yes, you can reliably make money from becoming a liquidity provider by earning a portion of the trading fees imposed by the DEX on traders. Bear in mind, however, that this all comes with its own caveats and risks you must understand. 

We’ll briefly cover some of the risks of becoming a liquidity provider, before discussing how liquidity providers can earn revenue from DEX trading.

Risks for Liquidity Providers

1. Security

While the idea of providing idle digital assets to a DEX’s liquidity pool for additional income may be appealing, it is important to note that the biggest risk you will take as a liquidity provider is that you will be putting your funds outside of the security of your own wallet.

This doesn’t mean you’re transferring your custody of the funds; you still control the digital assets and can always take them back, but you would have to trust that the automated scripts or codes that manage your funds will work as they should.

These scripts, called smart contracts, are the only ones controlling the way trades work in the liquidity pool and have no central authority or custodian taking care of them. Should a smart contract have a bug or vulnerability that can be exploited, your funds could be lost and no one would be able to help you reclaim them.

This risk is usually referred to as the smart contract Another thing that liquidity providers should keep in mind is smart contract risks. Once assets have been added to a liquidity pool, they are controlled exclusively by a smart contract, with no central authority or custodian. So, if a bug or some kind of vulnerability occurs, the coins could be lost for good.

Generally, younger or newer platforms that haven’t had their smart contracts properly or robustly audited will be the ones more at risk of security attacks. That said, even Uniswap, one of the oldest and most secure DEXs, was hacked in July 2022, allowing thieves to steal some $3.5 million in Ether from its liquidity pools.

2. Governance

While this might be considered a non-critical risk, it is important to note that DEXs are not generally as decentralised in terms of governance as they might suggest.

In fact, most DEXs actually are very much under the control of their own developers, who are able to implement changes and manipulations on their own. Some older DEXs such as Uniswap, have tried to transfer some of the control over to their community, in particular by distributing their own UNI token to users. In theory, UNI gives users the rights to vote on decisions taken by Uniswap, including new ideas and features and even developmental direction.

In practice, however, most governance tokens of DEXs are still concentrated in the hands of a few wealthy individuals and, often, their own developers. 

Should you be unfortunate enough to provide liquidity to a DEX controlled by developers who suddenly decide to go rogue with a hostile takeover of a liquidity pool’s assets, there wouldn’t be much you could do about it.

3. Impermanent loss

We finally arrive at the technical risk that liquidity providers are exposed to, which is impermanent loss.

To think of this in simple terms, consider that the dollar value of a liquidity providers assets could decline over time. For example, you could provide 1 ETH worth $1,500 and $1,500 worth of USDT into a pool. However, over the period of 24 hours, ETH price volatility is so high that it drops several times a day to $1,200 and even $1,000.

The loss happens if traders swapped out your ETH at these deep discounts. It is called impermanent because you don’t lose anything if the price returns to $1,500 – essentially, you don’t realise any profit or loss for as long as you keep your assets in the liquidity pool. 

During this period of extreme volatility, you could see a big loss due to impermanent loss. 

Since impermanent loss occurs due to trading pair volatility, most liquidity pools use at least one stablecoin in the pair (stablecoin values are pegged to fiat, so their value remains virtually unchanged). Perhaps the lowest risk of impermanent loss is when both assets in the liquidity pool pairs are stablecoins.

Liquidity Provider revenues

The attraction of liquidity pools is that it allows people to trade digital assets immediately and in an automated way, instead of the traditional way of CEXs where you are essentially putting up orders or taking other offers to sell and buy digital assets.

In other words, when you swap with a liquidity pool, your swap is automatically carried out, based on your settings. Prices are also determined automatically, with the DEX’s own mathematical formula that constantly adjusts based on the activity of trading as well as the general market value of the assets globally.

The other benefit is the lower cost associated with swapping or trading at liquidity pools on DEXs. While Liquidity Pools do charge a fee or commission for trading, it is typically a small percentage of the transaction value and often, not as high as that of a CEX.

This fee or commission is the main revenue generation for the liquidity providers since DEXs generally distribute most of the fees to liquidity providers as a reward for providing their assets to the liquidity pools.

Naturally, DEXs will try to entice more people to provide liquidity to their platform – the more liquidity you have, the easier it will be to attract traders with larger volumes since deeper liquidity also translates to lower slippage for traders (the difference in the price desired verses the actual price acquired).

As such, DEXs now offer more and more ways for Liquidity Providers to earn more income and diversify revenue other than through direct liquidity provision. This is usually achieved through further manipulation of LP tokens. How this happens and what LP tokens are is covered in the following section.

What are Liquidity Provider tokens or LP Tokens?

When people provide liquidity on decentralised exchanges or DEXs that operate on the automated market maker (AMM) protocols, they are usually issued separate tokens that represent their share of liquidity on the liquidity pools. These are called liquidity provider tokens or liquidity pool tokens, abbreviated as LP tokens.

Uniswap and SushiSwap are major DEXs on the Ethereum blockchain running such protocols, while there are others like PancakeSwap that run on the Binance Smart Chain network. Each of these DEXs issues LP tokens to their liquidity providers.

When considering their technical properties, LP tokens aren’t at all very different from most of the other tokens issued on the same network and usually take the form of ERC20 tokens (the most common type of utility tokens). Uniswap and Sushiswap, for example, both operate on top of the Ethereum network and issue LP tokens as ERC20 tokens. This then lets you transfer, trade and even stake them on other protocols, like you would any other type of token.

How LP tokens work

So if you were to contribute liquidity (in the shape of assets) to liquidity pools on these DEXs, you would be issued LP tokens. These tokens track your individual contributions to the overall liquidity pool and correspond in direct proportion to your share of liquidity in the overall pool.

The value of 1 LP token for a specific Liquidity Pool follows a simple formula:

Total Value of the Liquidity Pool / Circulating Supply of LP Tokens

For instance, if the total value of an ETH/USDT Liquidity Pool is $3 million and there are 1,000 ETH/USDT-LP tokens circulating, then each ETH/USDT-LP token would be worth $3,000 ( that is, $3,000,000 divided by 1,000).

As such, you can work out how many LP tokens you would get from the corresponding liquidity pool using the following formula:

Value of your contribution / Total Value of the Liquidity pool * Circulating Supply of LP Tokens.

For instance, if you provided $3,000 worth of ETH and USDT to an ETH/USDT Liquidity Pool, taking the total liquidity in the pool to $3 million, and there are 1,000 ETH/USDT-LP tokens in circulation, you would expect to receive:

3,000 divided by 3,000,000 multiplied by 1,000 = 1 ETH/USDT-LP token.

In other words, for providing 0.1% of the total liquidity in a Liquidity Pool, you would be issued 0.1% of the total LP tokens in circulation. You can easily see that your ownership share of LP tokens corresponds directly to your ownership share of the liquidity.

Holding LP tokens enables you, as a liquidity provider, to control how you want to lock your liquidity into the pool. As soon as you want to extract your contributed liquidity, you simple need to redeem your LP tokens on the corresponding liquidity pool. Once redeemed, you return your LP tokens and receive back your contributed liquidity (both assets, in equal dollar value, in the liquidity pool pair) plus your share of the commissions levied by the liquidity pool.

The relationship between LP tokens and the liquidity is almost always directly proportional, and this proportion is used to calculate:

  • How much your share of the transaction fees or commission earned during the period you provide liquidity.
  • How much liquidity (in the shape of assets) is returned to you when you decide to redeem your LP tokens for your contributed assets.

This commission is typically calculated at the same proportion of your contribution. For example, if you redeemed 1% of the total liquidity in the pool, you would also receive back 1% of any fees or commissions earned during the period you provided liquidity.

Today, there many other ways you can use LP tokens other than to provide liquidity to DEXs and earn commissions from that. Modern DEFI platforms even allow you to perform other financial transactions.

Two examples are farming and IDO qualification.

1. Farming LP Tokens

Some DEXs have a farming feature, which simply involves staking LP tokens to earn even more rewards. This encourages liquidity providers to ensure their liquidity is locked for longer in the pools. When staking LP tokens, you are usually given additional tokens – typically in the form of native DEX tokens. The longer you stake or lock, the more DEX tokens you get. For instance, if you stake LP tokens in PancakeSwap, the DEX rewards you with its own CAKE tokens, which you can sell or even further stake for additional revenue.

2. IDO qualification

Many DEXs also host what is called an initial DEX offering or IDO. These are new tokens created by companies to fundraise – very similar to initial coin offerings (ICOs) that were highly popular between 2016-2018.

In other words, IDO tokens are new tokens representing new companies that people can purchase as a form of investment. They hope that by buying these tokens, the companies issuing them can raise funds and build successful products that later cause their tokens to appreciate in price.

DEXs now also use LP tokens as a qualifying factor to access new IDOs they host. For example, to participate in an IDO, a DEX might require participants to also hold a certain number of LP tokens.

Popular DEXs for Liquidity Providers

There are a great many DEXs that utilise the AMM type protocol to create liquidity pools, which you can become a liquidity provider for. Here is a sample list of some DEXs and a brief explanation of their unique features.

1. Uniswap

Uniswap is one of the oldest DEXs around, and one of the first to distribute its own governance token. It boasts some of the biggest liquidity pools on the Ethereum blockchain. It has become expensive to use in recent years, though that is the fault of Ethereum’s network congestion leading to high gas fees to confirm transactions.

2. Bancor

Bancor was one of the pioneers of AMM type DEXs and liquidity pools and attempts to use complex algorithms to reduce volatility concerns. It has, however, fallen down the pecking order in terms of liquidity depth.

3. Balancer

As its name suggests, Balancer uses a type of protocol that attempts to balance multiple pooling options and ease of adjusting parameters for providing liquidity. It allows the farming option, but calls it liquidity mining.

4. Pancakeswap

Pancakeswap is the biggest DEX on Binance Smart Chain and does benefit from a strong affiliation to Binance – though it is in fact, independent from it. Because of its low fees and fast swapping times, it has rose as a serious challenger to the likes of Uniswap. The only issue is the requirement for blockchain bridges to allow for many popular coins and assets to be traded since the major assets don’t reside natively on Binance Smart Chain.

5. Curve

Curve bills itself as a decentralised liquidity pool for Ethereum-based stablecoin swapping. Because of its focus on stablecoins, it promises highly reduced slippage when compared with other liquidity pools, and an equally low impermanent loss. It might be quite limited for most traders who trade outside of stablecoins, however.

6. 1inch

Technically, 1inch is not a true DEX in itself, but is called a DEX aggregator which allows you to access many popular DEXs, including Uniswap and Pancakeswap mentioned on this list, from a single platform.

It is worth mentioning here, however, since you can still become a liquidity provider on any supported DEX, via the 1inch dashboard. In fact, it might even be easier for you to use 1inch to compare DEXs and liquidity pools since it displays estimated Annual Percentage Yield (APY) from various liquidity pools in real time.

In summary, liquidity pools are central to how DEXs operate but these rely on liquidity providers to be successful. They do provide opportunities for passive income but also come with some risks, which you should always bear in mind when considering whether to become a liquidity provider.