What is a Liquidity Provider (LP) and how to become one?

The liquidity pool system is an essential economic model in the DeFi ecosystem, discover its functionality.

Key takeaways

  • Liquidity is the lifeblood of traditional finance (TradFi), DeFi is no different… It always needs liquidity to work.
  • As of April 2022, around $220 billion dollars are provided as liquidity inside different DeFi protocols.
  • While Centralized Exchanges (CExs) rely on an order book system to allow their users to buy and sell cryptocurrencies, Decentralized Exchanges (DExs) - like Maya - use liquidity-pools models.
  • These users are commonly referred to as Liquidity Providers (LP’s) and earn yield on their deposited assets.

As you have read in our outline of Maya Protocol, Liquidity Providers, or simply LP’s, are a key piece to maintaining the security and sustainability of our network, and they get handsomely rewarded for it.

If you want to learn everything about providing liquidity we got you covered in this article, where we will see why LP’s are key to DeFi, how to easily become one, differences about providing liquidity symmetrically and asymmetrically liquidity, some of the major risks and benefits… Let’s unpack!

What is Liquidity and why does DeFi need it?

Liquidity describes the degree to which an asset can be quickly bought or sold in the market at a price reflecting its intrinsic value. It is also used in a more broad manner, and in combination with “deepness”, to describe the notional amount of capital available in a market, for example “postal stamps trade in less liquid and less deep markets than derivatives”, or, “Apple stock is way more liquid than IBM stock”.

The world of finance runs on liquidity, without available funds and deep markets, our financial systems would soon come to a halt. DeFi — a catch-all term for financial services and products on the blockchain— is no different.

Why is low liquidity problematic? If there is not enough of it, trading an asset becomes more expensive, because “slippage” starts to appear. Slippage is the price difference between the expected price of a trade and the price at which it is executed. This usually happens when a lot of people trade during periods of higher volatility but can also occur when buy or sell orders are large relatively to the available volume at acceptable prices.

According to Defillama.com, as of April 2022, there are around $220 billion dollars of value locked in DeFi protocols and the ecosystem is still rapidly expanding with new types of products. This is notable considering DeFi was ‘born’ in 2020 with protocols the likes of Compound, Bancor, and Uniswap!.

All this expansion was made possible thanks to the concept of liquidity pool replacing the order-book concept of traditional finance.

Order-book vs Liquidity Pools

An order-book model features an internal engine that matches users’ buy and sell orders between each other. This model is great for facilitating efficient exchanges and has allowed the creation of complex financial hubs, like the stock and derivatives markets. Most Centralized Exchanges (CExs), like Binance or Huobi, use order books.

With DeFi, however, because trading involves executing trades on the blockchain - without any third-party company holding any funds - an order book model for exchanging is practically impossible, it would incur in a tremendous amount of transactions, clogging the network and demanding huge gas fees.

DEXes instead use the Liquidity Pool model, which is technically named “Automated Market Maker” (AMM) model and which is also a significant innovation that allows for on-chain trading without the need for order books. This way, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges.

Liquidity pools are the smart contracts that contain all of the crypto tokens that have been supplied by the platform's users and are the counterpart to anybody that engages in a trade.

Users act as Liquidity Providers (LP’s) by adding, usually, an equal amount of two tokens inside a Liquidity Pool to create a market. We will see how asymmetric provision is an exception to this rule.

In exchange for providing their funds, users earn a share of the fees generated by the Pool whenever trades happen. Because anyone can be a liquidity provider, even with small amounts of money, it is said that AMM’s have made Market Making more accessible.

How do Liquidity Pools work?

For someone to buy token A in exchange for token B in a DEX, they need a “token A / token B” liquidity pool, with the assets provided by other users. If someone buys, for example, a lot of the B tokens, they become more scarce inside the pool and their price rises. Whenever a pool is used to facilitate a trade, a small fee is distributed proportionally among the Liquidity providers.

LP’s by the way, obtain temporary ‘receipt’ tokens in exchange for their contributions, called “LP tokens”, which they can trade back in to get their original assets plus any of these mentioned profits.

Benefits of providing liquidity to a pool

Liquidity provision can be a lucrative investment. As we mentioned before, providing liquidity into a pool entitles you to a proportional cut of the fees generated by the users and traders. Moreover, since Liquidity is the lifeblood of DeFi, most protocols incentivize liquidity providers by awarding them with other incentives, usually governance tokens, which have a monetary value themselves.

This incentive structure has given rise to a crypto investment strategy known as “yield farming” or “Liquidity Mining” which seeks to maximize these rewards across different protocols and AMM’s.

By contributing your tokens into liquidity pools - instead of leaving them accumulating dust in your wallet - you are also contributing to making DeFi markets more efficient.

Risks of providing liquidity to a pool

When providing liquidity into a DEX, you need to be aware of what is called “Impermanent Loss”. We recommend that you read our article on Impermanent Loss and how Maya goes the extra mile to mitigate it but, in short, this is a loss in dollar value terms that you can absorb while providing liquidity under certain situations.

Smart contract risks

Another thing to keep in mind is Smart Contract risks. Because whenever you deposit funds into a liquidity pool, they actually leave your wallet and are being held in the pool’s smart contract, there is always the chance of bugs or vulnerabilities that can be exploited (ex. hackers often use flash loans to drain pools). 

How to add liquidity to a Maya pool

Here are two options to add liquidity into Maya Protocol, we will also be releasing a detailed step-by-step guide on how to do it on our website soon. For now, let’s understand the theory behind them:

Option #1: Symmetric Liquidity

Liquidity Pools usually have a 50:50 asset ratio and, in the case of Maya, one of these assets is always $CACAO. 

The natural way to contribute liquidity into one of these pools, then, is via “symmetrical” deposits, where liquidity providers deposit both assets in exactly the same amount - as measured in USD dollars. For example, to add funds to the ETH/CACAO liquidity pool, you will need to have $100 USD worth of ETH and $100 USD worth of $CACAO.

Many DEXs allow Symmetrical deposits.

Option #2: Asymmetric Liquidity

In Maya, users can also deposit “Asymmetrically”, meaning they only contribute one asset into any pool. For example, if a user does not own any $CACAO, but still wishes to provide liquidity into the ETH pool he can still do it with only this coin because Maya’s code will automatically swap half of the deposited ETH into $CACAO (swap fee is dependent on the size of the deposit vs the depth of the corresponding pool). There are two advantages of doing this:

  1. The liquidity provider will have price exposure to both assets, but he will not have had to get ahold of $CACAO before hand, making the process more straightforward and easy.
  2. You don’t trigger any taxable event when providing liquidity with Maya, because you did not not swap your assets manually before adding them to our pools. Usually, if you had swapped some of your ETH into $CACAO, you would have incurred a taxable event - comparing the selling price of ETH to your acquisition price of ETH and calculating any taxable profits.