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.
  • You can provide liquidity to Maya by becoming an LP or a Liquidity Node.

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 liquidits. 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 Maya pool

  • Earning yield on deposited assets in the form of $CACAO and the pool's connected asset.

  • Yield is calculated every block and paid out upon withdrawal of assets from the pool.

  • Rewards are based on the fees collected per pool when swap transactions occur or on the amount of assets in the pool if no trades are present in a block.

  • Liquidity providers can earn a percentage of the transaction fees generated by swaps when pairing assets like $CACAO with other assets in liquidity pools.

  • Impermanent Loss Protection ensures that liquidity providers either make a profit or break even after a minimum period of time.

  • Liquidity providers are allocated rewards proportional to their ownership of the pool.

  • The opportunity for holders of non-yield generating assets to obtain a return on their investments.

How to add liquidity to Maya?

Maya offers two distinct methods for users to contribute liquidity, each with its unique approach and benefits. Below, we delve into these methods, providing a clear and detailed understanding of both.

Becoming a Liquidity Provider:    

Maya is integrated with seven distinct user interfaces, each offering a unique experience. These include THORWallet, El Dorado, Rango Exchange, XDEFI, Asgardex, Leap Wallet, and Pulsar.    

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.

To assist you in this process, comprehensive step-by-step guides are available here. These resources are designed to streamline your journey in becoming a liquidity provider, ensuring a smooth and efficient experience.

Becoming a Liquidity Node:

One of Maya's unique features is the option to become a Liquidity Node. This role differs significantly from a typical liquidity provider. It requires a deeper understanding of Maya's infrastructure and potentially offers greater influence and rewards within the ecosystem, you can read more here.  

In the Liquidity Node model, nodes earn both Node rewards and Liquidity Rewards, reducing risk and promoting deeper pools. This dual-earning capability creates a liquidity flywheel, attracting more liquidity, reducing swap fees, increasing trade volume, and ultimately generating more yield.

Where does the yield come from?

In MayaChain, fees earned from swaps and transactions are divided into two types of rewards:

  • Node Exclusive Rewards (NER): Rewards exclusively given to Liquidity Bonded to MAYANodes, distributed evenly among all Nodes.
  • Liquidity Pool Rewards (LR): Distributed to all LPs, including Bonded Liquidity, based on their share of liquidity.

In other words, LR is earned by ALL liquidity provided to MAYAChain (bonded or not), and the NER is only provided to those who Bond their Liquidity. While Liquidity Bonded to MAYANodes earns NER, Node operators set a fee for providing their services, further enhancing the overall yield potential.

Final thoughts

Both paths offer valuable opportunities to contribute to Maya's liquidity. Whether you choose to be a Liquidity Provider or a Liquidity Node, your participation is pivotal in enhancing the platform's functionality and user experience. Remember, the choice depends on your personal investment strategy, technical expertise, and desired level of involvement in Maya's growing community.

Eager to get involved but have questions or uncertainties? We're here to help! Our team is readily available to address any doubts or queries you may have. Join us on Twitter and Discord!