What Does a Liquidity Provider Do in Crypto?

During the average crypto trade, a lot goes on behind the scenes. The exchange you work with may enlist help from brokers, liquidity providers and other third-party assistants. Understanding how these services work can create some unique investment opportunities for you. In this guide, you'll learn all about liquidity providers. Not only can you discover how liquidity providers affect your trades, but also how to become a liquidity provider and start earning extra money.

Key Takeaways:

• A liquidity provider (LP) is an independent entity or individual who holds a pool of liquid assets. The liquidity provider functions as a middleman who supplies exchanges with the crypto they need to fulfill an order.
• In exchange for providing liquidity, LPs are given liquidity provider tokens that act as a receipt for their initial investment. In addition, they receive rewards for providing liquidity.

What Is a Liquidity Provider?

A liquidity provider (LP) is an independent entity or individual who holds a pool of liquid assets. The liquidity provider functions as a middleman who supplies exchanges with the crypto they need to fulfill an order.

Liquidity providers are used in stock markets, foreign exchanges, crypto markets and other institutions that trade assets. They come in many different forms. An LP can be a market maker, investment bank, trading firm, other financial group or an individual. In many modern crypto communities, a liquidity provider is a decentralized autonomous organization (DAO) that pools funds from multiple community members.

How Do Crypto Liquidity Providers Help Generate Liquidity?

To understand what liquidity providers actually do, it's necessary to take a look at how the average trade works. Consider a case where a buyer puts in an order for a specific amount of crypto. Without a liquidity provider, an exchange would have to browse around until they find a seller who’s offering that amount of liquid crypto. Depending upon the coin, it could be tricky to discover someone offering the right crypto at a fair market price. This is where liquidity providers are useful.

When an exchange is working with a liquidity provider, the provider automatically supplies any order. A buyer places the order, and then the exchange takes the precise amount of ordered tokens from the LP and gives it to the buyer. Then, the next time someone sells the same type of token, the exchange will collect those digital assets and deposit them back with the liquidity provider.

Essentially, the overall amount of tokens the liquidity provider owns remains the same in the long run. However, the individual tokens will be swapped out and replaced with others, and the value may temporarily fluctuate as exchanges remove and deposit tokens. To help regulate this system, some liquidity networks may give these individuals liquidity provider (LP) tokens, which act as receipts for their initial investments.

Benefits of Being a Liquidity Provider

Why do individuals choose to become liquidity providers? There are several perks.

Passive Income

The main reason so many people are interested in providing liquidity is for passive income. To incentivize liquidity providers, exchanges offer them a portion of the fees each trader makes. Depending upon the type of coin and the exchange you work with, you can earn between 0.05% to 1% of the asset value per each trade for which you supply liquidity as an LP. Thus, if you plan on holding your tokens for a while, you can put them to use and earn extra income, in addition to the money you may make if your tokens increase in value over time.

Reduced Risk

Being a liquidity provider also reduces your overall risk. When you provide liquidity, you don't have to put a lot of money into betting on the market. Unlike purchasing options, an unexpected market movement can't cost you thousands. As long as people are trading, you're earning money — and you get to take back all of your original crypto assets at the end.

Reputation

Being a liquidity provider is more than just a chance to earn money. It allows you to get more involved in the trading process. As a liquidity provider, you can build a positive reputation and help to prevent illiquid markets, so more opportunities open to you. You can potentially meet new business partners through networking, and building your reputation can also allow you to seek more lucrative liquidity-providing contracts.

Risks of Being a Liquidity Provider

Liquidity providing can certainly be rewarding, but it's not going to work perfectly for everyone. Here are a few potential risks to be aware of.

Impermanent Loss

Impermanent loss (IL) is the leading danger when working as a liquidity provider. It occurs due to constantly fluctuating market prices, and can happen whenever a liquidity provider is swapping two types of crypto with different prices. If the value of one crypto falls in relation to the other, the liquidity provider may notice a decline in their overall balance of funds when they exchange their LP tokens for actual funds. 

Whether or not you encounter impermanent loss tends to depend upon the coins you offer and the organizations you work with. On certain sites with unfavorable rules for liquidity providers, rates of impermanent loss can be as high as 50%.

Smart Contract Risks

Like any other financial arrangement, the safety of being a liquidity provider depends upon the security of the contracts you use. Liquidity providers rely on smart contracts to ensure they get paid the correct fees, and they get their money back at the end of the experience. If you end up working with an unreliable system and its smart contracts get hacked, you could lose your money and/or compromise your privacy.

Front-Running

Front-running occurs when traders pay extra fees to move their transactions to the front of the line. By getting their transactions processed before those of competitors, traders can take advantage of minor changes in the market and make more money. Certain types of front-running can also harm LPs by keeping them from getting a fair fee for their services.

Benefits of Using a Liquidity Provider

Even if you have no interest in becoming a crypto liquidity provider yourself, it can still be quite useful to work with LPs because of the benefits they provide for all market participants.

Stabilize the Market

Liquidity providers help to keep pricing somewhat consistent. Without them, a single large purchase or sale can drastically affect the market. However, exchanges can use multiple LPs to fulfill these orders without directly affecting supply and demand. 

The algorithms used by the average automated market maker also help to regulate markets by ensuring there’s a consistent number of tokens in liquidity pools. Crypto market prices still go up and down, but in a liquid market, they don't swing around as wildly or experience sudden changes due to a single purchase.

Reduce Spread

Market spread refers to the discrepancy between the price at which a seller will sell and the price at which a buyer will buy. While liquidity providers supply assets to the pool, it’s the exchange or the AMM that utilizes these assets to provide trading quotes and set prices. As liquidity is added to the pool, it helps reduce the spread by ensuring a more consistent and stable price between buying and selling. 

Not only does a smaller spread stabilize the market and prevent volatility, but it also makes things a lot easier for market participants who like working with options. When market spreads are smaller, it's much more affordable to work with pairs of options.

Increase Trading Activity

Crypto liquidity providers ensure that trading never has to stall due to an illiquid market. When investors can buy and sell on demand, they trade more frequently. Furthermore, increased stabilization and market reliability help to reassure people who otherwise may become frustrated by the trading process. All of these factors combine to create higher trading volume, which in turn provides more investment opportunities.

Risks of Using a Liquidity Provider

Liquidity providers are useful, so most modern exchanges work with them. However, there are a few potential downsides that accompany the use of LPs.

Slippage

Slippage can occur whenever the actual price of an executed trade is different from the price expected. It usually happens when markets are so volatile that orders change in the brief moment between a trader placing the order and an exchange fulfilling it. Since crypto liquidity pools reduce volatility, a liquid market usually has less slippage. However, if the liquidity pool isn't deep enough, slippage still may occur. Trying to rely on liquidity pools as a guarantee against slippage is inadvisable, and can lead to unwelcome surprises.

High Gas Fees

Liquidity providers offer their services in exchange for money, which results in higher fees for traders. Every time you conduct a trade that goes through an LP, they need to be compensated. Most exchanges pass this fee on to the consumer, so you can expect to pay more when you trade through a platform that uses liquidity providers.

Liquidity Provider vs. Market Maker

A market maker is a type of trading intermediary, typically a member of a bank or high-frequency trading firm, who uses their own account to buy and sell crypto for the sole purpose of adding liquidity to the market. Market makers usually work alongside brokers or exchanges to help ensure that customers can fulfill their trades, regardless of market liquidity. They essentially "make" the market by working to reduce market spread, stabilize the market and facilitate trades. 

In the modern crypto world, many market makers are actually bots. Called automated market makers (AMMs), these types of systems run on software designed to maintain the exchange.

Technically speaking, a market maker can be a sort of liquidity provider. However, it's only one specific type of liquidity provider, while the overall category of LPs can include many other types of entities or organizations. 

The goal of a market maker also tends to be different from that of the traditional crypto liquidity provider. Market makers work on keeping a specific exchange operational and competitive, while the goal of most liquidity providers is simply to earn money by facilitating trades.

How to Become a Liquidity Provider

Becoming a liquidity provider is simpler than you might think, especially with the multitude of platforms and services available. Here’s a step-by-step guide to becoming a crypto liquidity provider:

Research and Choose a Platform: Before you become a liquidity provider, you need to decide on a platform. Each one has its own fee structure, supported asset and community. Popular decentralized exchanges like Uniswap are known for their simplicity and wide range of supported tokens, while centralized platforms like Bybit are recognized for their security and liquidity mining features.

Get the Necessary Cryptocurrency: Most platforms require you to deposit an equal value of two tokens to provide liquidity. For instance, if you're providing liquidity for an ETH/USDT pair, you'll need to deposit both ETH and USDT.

Connect Your Wallet: For decentralized exchanges, you'll typically connect a digital wallet like MetaMask. For centralized exchanges, you simply deposit your crypto directly into your account on the platform.

Deposit Your Funds: Once your wallet is connected, you can add your funds to the liquidity pool of your choice. This often involves interacting with a smart contract that locks up your funds and issues you LP tokens in return.

Start Earning Fees: As traders swap tokens in the pair for which you're providing liquidity, you'll start earning a portion of the trading fees. These fees are typically added to the pool, increasing your share.

Monitor and Manage Your Investment: Regularly check on your investment. Ensure you're aware of any potential impermanent loss and keep track of the fees you're earning.

Bybit Liquidity Mining

If you’re looking for a fuss-free way to provide liquidity, Bybit offers Liquidity Mining, which is designed to reward users for providing liquidity. Here’s how it works:

Join the Program: Access Bybit's Liquidity Mining and choose the crypto pairs you wish to provide liquidity for.

Provide Liquidity: Just as with other platforms, you deposit your tokens, which will be used to facilitate trades.

Earn Rewards: Bybit’s Liquidity Mining rewards you with an APR of up to 35.1%. 

Should You Be a Liquidity Provider?

If you like holding crypto for extended periods of time to earn passive income, being a crypto liquidity provider can be a smart move. It's a great way to make money off of your crypto, while also helping crypto exchanges to function properly. Thanks to a myriad of intriguing web3 projects, it's also very easy to become a crypto liquidity provider. For instance, you can join a liquidity pool, and you don't even need large sums of crypto assets before becoming an LP.

Keep in mind that the specific organization you work with can make a huge difference. Not only do you get different fees through certain liquidity pools, but you also encounter different regulations. For example, some companies may use special algorithms to help manage digital assets and prevent impermanent loss. Choosing the right liquidity pool for you can result in a more profitable experience.

The Bottom Line

Crypto liquidity providers are an often overlooked but essential part of the crypto market. By providing market liquidity, they help to reduce volatility, speed up trades and increase trading volume. Not only do they provide valuable services, but crypto liquidity providers also get to earn passive income. If you're interested in becoming a liquidity provider, check out one of the many crypto liquidity pool options available.

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