What is Liquidity Provider in DeFi?
Who are Liquidity Providers? What role do they play in decentralized finance? Why do we need liquidity providers in DeFi? What is decentralized finance? All of this and more would be explained in some detail in this article.
A liquidity provider is a decentralized exchange user who funds a liquidity pool with crypto assets or tokens he/she owns to promote trading on the platform being used and earn income passively on the deposit made.
What are Liquidity Pools?
Liquidity pools are collections of several tokens or assets that are fixed in a smart contract. They are utilized in trading to foster liquidity and are largely used by some of the decentralized exchanges also known as DEXes.
Bancor was one of the first projects to introduce liquidity pools, but Uniswap popularised its usage.
What is Decentralized Finance?
Decentralized finance (generally known as DeFi) is a form of peer-to-peer donations running on cryptocurrency blockchains, most commonly Ethereum.
DeFi is said to offer high-interest rates, with some providers offering triple-digit interest rates, but it is subject to high risk. Those who aren't experienced are at higher risk than experienced investors.
We will explain how liquidity providers work but before then, let’s try to understand what makes them important in the first place.
Why are Liquidity Providers Needed in DeFi?
The liquidity provider plays the role of a middleman in the foreign exchange market. Their role is to ensure that buyers and sellers have access to the tokens they want at any given time. To achieve this, the liquidity provider may buy and sell tokens simultaneously, to keep it "liquid" or available.
Ideally, the liquidity provider brings greater stability of prices to the markets, to enable on-demand distribution of tokens and assets to all investors. Without their contribution, it would not be guaranteed that tokens or assets would always be available to investors, and the ability of buyers and sellers to buy or sell whenever they need to would be diminished.
Liquidity providers sell their assets while simultaneously buying more, thereby creating a market for those assets. With this, there is an increase in the volume of sales, which also allows investors to buy tokens at any given time without having to wait for when it would be made available depending on another investor's willingness to sell.
How Do Liquidity Providers Carry Out Their Work?
We now know why liquidity providers are of importance in decentralized finance, so let’s look at how they work.
The liquidity provider to bid first on a newly created liquidity pool sets the original price of the assets in the pool. He/she is now given an incentive to procure equal values of both assets to the pool. The liquidity provider is intermediately put at risk of losing his/her capital if the fixed price of the tokens in the pool is different from the price of the current global market.
Special tokens called LP token are given to liquidity providers whenever they supply liquidity to any given pool. This is determined by how much liquidity was distributed to that pool. When the pool facilitates a trade, all the LP token holders receive a 0.3% fee, proportionally distributed among them. These LP tokens are taken away if the liquidity provider decides to retrieve their underlying liquidity and any accumulated fees.
How Do Liquidity Pools Work?
One liquidity pool contains 2 tokens at the very least, and each pool generates a new market for that specific pair of tokens. DAI/ETH is a good example of a well-known liquidity pool on Uniswap.
For each token exchange facilitated by a liquidity pool, there is a resultant adjustment of prices according to a determined pricing algorithm. A mechanism called Automated Market Maker (AMM) is employed and different liquidity pools with different protocols may use an algorithm with slight differences between them.
Most commonly used liquidity providers use a regular product market maker algorithm that ensures that the quantities of any two accessible tokens never change. Also, because of this special algorithm, a pool can always procure liquidity, it doesn't matter the size of the trade. The sole explanation for this is that as the quantities of the tokens reach the desired amounts, the algorithm increases the price of the token simultaneously.
The important thing to note here is that the amount of tokens in the pool determines the price. So for instance, if you purchase ETH from a DAI/ETH pool, the supply of ETH will be reduced in that pool while the supply of DAI will increase. The resultant effect is that the price of ETH will increase an increase while the price of DAI will fall (due to forces of demand and supply). How much increase or decrease in prices depends on how big the trade is, in proportion to the size of the pool. The bigger the pool, the lesser the price impact or slippage occurs. Hence, large pools will accommodate large trades without greatly affecting the price of each asset.
Some programs like Balancer started providing liquidity providers with incentives like extra tokens to encourage them to supply liquidity to certain pools. This is a process called liquidity mining.
As with everything else in DeFi, it is necessary to keep in mind and be aware of the potential risks that are always there. Besides the normal DeFi risks like smart contract bugs, admin keys, and systemic risks, we have to consider two new risks — permanent loss and the potential for liquidity pool hacks.
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