In the cryptocurrency and DeFi (Decentralized Finance) industry, the term is used Liquidity Providers (LPs) refers to users of a decentralized exchange (DEX) who fund a liquidity pool with crypto assets they own.[1] [3]
The crypto assets are used to facilitate trading on Automated Market Makers (AMMs) such as Uniswap, SushiSwap and MindSwap. Liquidity providers often provide two or more types of tokens and earn passive income from their deposits.[2] [4]
useful information
- In exchange for providing funds, users receive trading fees from the trades that take place in their liquidity pool in proportion to their share of the total liquidity.
- Users providing liquidity need to keep smart contract risks and temporary losses in mind.[5]
- Since anyone can be a liquidity provider, AMMs have made market making more accessible. [6]
Typically, when users fund liquidity pools, they need to fund two different assets for traders to switch between them by trading them in pairs. [7]
Liquidity pools in DeFi
Liquidity pools are used by decentralized exchanges that use automated market maker based systems to enable trading of illiquid trading pairs with limited slippage. Instead of using traditional order book based trading systems, such exchanges use funds held for each asset in each trading pair to allow trades to be executed. [8]
While trading illiquid trading pairs on order book exchanges can lead to severe slippage and the inability to execute trades, the advantage of liquidity providers is that trades can always be executed as long as the liquidity pools are large enough. [9]
Other popular exchanges that use liquidity pools on Ethereum are Curve Finance and Balancer. Liquidity pools in these protocols contain ERC-20 tokens. Similar equivalents on Binance Smart Chain (BSC) are PancakeSwap, BakerySwap (BAKE) and BurgerSwap, with pools containing BEP-20 tokens. [11]
Liquidity pooling can be used in a number of ways, such as yield farming or liquidity mining. Liquidity pools are the basis of automated income generation platforms like yEarn, where users deposit their funds into pools which are then used to generate income. [12]
When a user provides liquidity to Uniswap or lends funds to Compound, they are rewarded with tokens representing their share of the pool. Users can also deposit these tokens into another pool and earn a return. These chains can get quite complicated as protocols incorporate other protocols’ pool tokens into their products, and so on. [13]
Example of a liquidity provider
A liquidity provider can provide a liquidity pool of $5,000 in (ETH) and $5,000 in DAI to enable trading between the two. Each time a trade is executed in the ETH/DAI liquidity pool, the liquidity provider in question receives compensation for funding the pool in question.[10]
When Liquidity Providers successfully provide liquidity to one of the liquidity pools on the DEX, they receive Liquidity Provider Tokens or LP Tokens as a receipt, allowing them to claim their original interest and interest earned. These LP tokens signify ownership of the associated liquidity in the pool. The LP tokens track individual contributions to the liquidity pool and are proportional to the liquidity’s share of the overall pool. These LP tokens can still be used for yield farming, collateral for loans, and many other uses.
[14][15]
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