Liquidity Provider

November 21, 2023 - Around 2 mins mins to read

Understanding the Role of a Liquidity Provider

A Liquidity Provider (LP) plays a vital role in facilitating trading activities on a platform by contributing their own cryptocurrency assets to a liquidity pool. This not only ensures smooth trading but also allows them to earn passive income from their deposits.

Decentralized exchanges rely on liquidity pools, which are supported by automated market maker-based systems. These pools enable the trading of illiquid trading pairs with minimal slippage. Unlike traditional order book-based exchanges, decentralized exchanges utilize funds held for each asset in every trading pair to execute trades.

Trading illiquid trading pairs on order book-based exchanges can lead to significant slippage and the inability to execute trades. However, Liquidity Providers offer a solution to this problem. As long as the liquidity pools are sufficiently large, trades can always be executed. This makes Liquidity Providers essential in facilitating trades, and they receive compensation through transaction fees paid for the trades they enable.

The compensation received by Liquidity Providers is determined by the percentage of liquidity they provide to the pool. Typically, they are required to contribute two different assets to enable traders to switch between them by trading in pairs.

For instance, a Liquidity Provider may contribute $5,000 worth of Ether and $5,000 of the USD-pegged decentralized stablecoin DAI to a liquidity pool. This allows traders to easily trade between ETH and DAI. Each time a trade is executed on the ETH/DAI pair, the Liquidity Provider receives compensation for their contribution to the pool.