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Who Are Liquidity Providers

Oct 16, 2023
7 min read

This blog post will cover:

  • Liquidity providers explained
  • How does liquidity provision work?
  • Why are liquidity providers important for the market?
  • What are the risks of being a liquidity provider?

Liquidity providers are a part of the Crypto World which often goes unnoticed. Even though we rarely think about what exactly goes into the behind-the-scenes of crypto transactions, their contribution to seamless DeFi operations is hard to overstate. What is more, fulfilling this role might become a lucrative investment opportunity.  

Today, we are going to look into how liquidity providers operate and affect the cryptocurrency market.

Liquidity providers explained

Liquidity providers (LPs) make sure that there is an adequate number of buy and sell orders within specific cryptocurrencies or trading pairs. By doing so, they contribute to establishing a fluid market environment, which is a must for price stability and optimizing the efficiency of trading operations. Though the crypto market is well-known for its volatility, liquidity pools help mitigate the influence of trading activities on price levels, which would have been worse without them.

These can be individuals, institutions, or software, and they typically fall into one of these categories:

  1. Market makers. These people or entities create orders to trade crypto assets at specific price levels. They do this to benefit from the spread (the discrepancy between the bid and ask prices). Currently, automated market makers, or AMMs (bots), are very widespread in the crypto sphere. Such projects as Maverick Protocol and Uniswap are examples of using AMMs.
  2. Trading firms. Many professional trading companies utilize advanced algorithms and strategies to make the cryptocurrency market more liquid. They automate the execution and cancellation of orders to profit from minor price discrepancies.
  3. Cryptocurrency funds. Some cryptocurrency funds and investment firms engage in liquidity provision as part of their trading strategies. They use some of their assets to do what market makers do on various exchanges.
  4. Decentralized exchanges (DEXs). There, LPs deposit assets into liquidity pools. As a reward, they receive some of the trading fees that the users pay. Curve Finance can be considered an example of such DEX. It has over 200 liquidity pools, which include BTC, ETH, USDT, etc.

How does liquidity provision work?

LPs enter both purchase and sale orders for a cryptocurrency or trading pair within an exchange or trading platform. The orders are systematically positioned at diverse price points, which gives traders several options to choose from.

They watch the market trends and adjust their orders as needed. LPs have the flexibility to change both the prices and quantities of their orders. This allows them to align with ever-changing market dynamics and uphold a competitive spread.

Furthermore, LPs give the order book depth, creating a number of orders at various price tiers. An extensive order book holds immense appeal for traders, as it empowers them to execute sizable transactions while encountering minimal price slippage.

Many LPs use advanced trading algorithms and software. They can adjust quickly to market changes as well as execute orders with minimal latency.

Here is how this system works. In a DEX, users can trade one cryptocurrency for another directly without relying on a centralized intermediary. LPs contribute by depositing into liquidity pools an equal value of two cryptocurrencies. The pools are utilized for exchanging the tokens. For instance, a liquidity provider might deposit $1,000 worth of BTC and $1,000 worth of, say, USDT.

By doing so, LPs create a balanced trading pair, which allows users to swap between BTC and USDT seamlessly. In return for their input, liquidity providers receive a portion of the platform’s fees which the traders pay. 

Why are liquidity providers important for the market?

There are several reasons why LPs hold a lot of significance for the industry on the whole.

As we have mentioned above, their activity helps with making crypto prices less volatile by providing plenty of buy and sell orders at any given moment. When the market is illiquid, even small trades have the potential to cause noticeable price fluctuations, leading to the market becoming extremely unstable and unattractive to lots of crypto traders and investors alike. LPs help dampen these price swings.

Moreover, in crypto markets characterized by robust liquidity, users can quickly trade their assets at their preferred prices. The lack of LPs can pose challenges for traders seeking to transact substantial assets, potentially resulting in significant price slippage, where the actual execution price is significantly different from the expected price.

Also, LPs help with the confidence of various market participants. Lots of accessible orders at any time give users a reason to believe in the market's integrity. Such confidence has the potential to increase trading activity and even lead to broader crypto adoption.

What are the risks of being a liquidity provider?

Being an LP can bring users passive income without having to do any transactions of their assets. At the same time, some risks come with this opportunity.

For example, impermanent loss. It occurs when the price of one of the tokens in the liquidity pool experiences significant changes compared to the initial deposit. As a consequence, liquidity providers may receive fewer assets than their initial deposit when they decide to withdraw from the pool.

Another factor to consider is imbalance, which makes it necessary to continuously monitor the prices to ensure that the asset ratio they supply remains stable. Significant imbalances in the pool can lead to diminished earnings or even losses.

Furthermore, in DEXs and on trading platforms, LPs deal with smart contracts. These smart contracts can be vulnerable to exploits, potentially resulting in the loss of deposited assets.

In summary, it is not an overstatement to view liquidity providers as the backbone of the crypto market. Their contributions enhance the efficiency and profitability of crypto trading for all participants. While liquidity providers may encounter some risks, engaging in this activity remains a compelling investment opportunity.

SimpleSwap reminds you that this article is provided for informational purposes only and does not provide investment advice. All purchases and cryptocurrency investments are your own responsibility.

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