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.
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