Everything You Need to Know About Becoming a Liquidity Provider

Since the first successful decentralized exchange in 2017, DEXs have exploded in popularity. DEXs like Uniswap often process billions of dollars in trades from market participants without needing a centralized third party like an exchange or broker. It’s all done through the power of smart contracts, and that’s the beauty of decentralization over financial institutions.

Yet, DEXs often face a persistent challenge — liquidity. Market liquidity is important because it determines how quickly and efficiently parties can buy or sell an asset — crucial in a market where split-second decisions can result in significant losses or gains. That’s exactly where liquidity pools come in.

Liquidity pools help keep the trading process truly decentralized without an order book, and liquidity providers (LPs) play a key role in their functioning. As a crypto liquidity provider, you make your tokens work for you by adding available liquidity to the crypto market — and, in turn, you are rewarded for ensuring greater price stability and playing your part in maintaining a liquid market.

Let’s understand how liquidity pools work, what a liquidity provider is and everything you need to know to become a liquidity provider.

What is a Crypto Liquidity Pool?

A liquidity pool is like a shared community pot containing usually one trading pair, like Ethereum (ETH)/Tether (USDT), or ETH/DAI. Technically, it is a smart contract that locks up two or more cryptocurrencies to maintain a reserve that facilitates trades, whether it be between buyers and sellers or two parties who might want to conduct a token swap.

Think of it as a jar containing two tokens, let’s say BTC and USDT. LPs keep adding equal amounts of BTC and USDT to ensure the jar always has tokens available. Now let’s say someone wants to exchange their BTC for USDT. They can simply trade with the liquidity pool — put in their BTC and receive USDT or vice versa.

To trade with the liquidity pool, a trader has to interact with automated market maker (AMM) algorithms. AMMs serve two purposes — they help automate trade execution and determine token prices based on market conditions. AMMs are the key to replacing order books. When traders interact with the AMM, it helps execute peer-to-contract trades. There’s no need for a counterparty for trade execution as with order books, making trading faster and more efficient.

Types of Liquidity Pools and How They Work

Becoming an LP comes with learning a lot of new terms. But don't worry, here we will walk you through the key terms and types of pools you need to know to get set up as an LP. You'll also learn how users on both the buy and sell side would use the particular assets that you contributed as they're trading on the market.

The most common types of liquidity pools are constant product pools. In these pools, the product of the token quantities remains constant at all times. Similarly, there are constant sum pools or balancer pools, where the sum of the token quantities remains constant. In both constant product and constant sum pools, the AMM automatically adjusts token prices after each trade.

Another important type of pool is the stablecoin pool. These pools are designed to make stablecoin trading efficient by minimizing losses due to price slippage.

Price slippage is a key term for you to remember and refers to the difference between the price at which a trader wants to sell and the actual selling price of the token. Price slippage occurs when the liquidity pool is insufficient for a big trade. In these cases, trying to execute the trade negatively impacts the price of any coin, resulting in losses for the trader.

Apart from these, there are also dynamic fee pools, hybrid pools, and more, but this is enough to get you started. A thing to note, however, is that several protocols improve on these traditional pool models.

Take Trust Machines' LNSwap application, for instance. It is a decentralized swap protocol that allows users to swap Bitcoin for cryptocurrencies on the Stacks layer and vice versa. It uses crypto liquidity providers to maintain the efficiency of its platform.

LNSwap is different from traditional liquidity pools since you have to run your own Bitcoin and Lightning node. In typical liquidity pools, you can leave it up to the blockchain. The LNSwap smart contracts are just responsible for locking and releasing assets during the swap — the participants directly control the rest of the process.

Your Role as a Liquidity Provider

Let’s say you deposit equal quantities of BTC and USDT to a BTC/USDT pool. In exchange, you will receive cryptocurrency liquidity provider tokens, which will represent your contribution to the pool.

You can always withdraw your tokens from the pool by exchanging your LP tokens by interacting with the pool smart contract. You can also trade LP tokens like any other crypto currency, although their liquidity may vary.

For your role as a liquidity provider in helping ensure trading efficiency and maintaining stability, you will receive rewards. The rewards are proportional to your contribution to the pool and are usually a share of the fees generated from trades.

Some liquidity pools also provide additional incentives like yield farming and governance tokens.

Benefits and Risks of Providing Liquidity

As an LP, your primary benefit will be the rewards you earn. These rewards are a passive source of income for you. You will also have flexibility in managing your assets since it is relatively easy to add or remove liquidity. More importantly, you’d be supporting the growth of the DeFi ecosystem by ensuring market stability, efficiency, and accessibility.

However, one of the key risks you need to know is ‘Impermanent loss’. When you deposit your tokens in a liquidity pool, you do so in a certain ratio. Now, if the price of the actual tokens changes, you face a loss because the product or the sum remains constant in both constant product pools and constant sum pools.

As an LP, you would also have to consider the possibilities of an imbalance risk. If one of the tokens in the trading pair has more demand or supply, it can create an imbalance. This would impact trading opportunities and lead to losses since your capital will not be utilized optimally.

There’s also the risk of smart contract vulnerabilities. To avoid staking in a liquidity pool whose smart contract may be vulnerable, you should always vet the smart contract code if it’s open-source. Remember, you are taking on an amount of risk by giving assets to a third party, so you must thoroughly research to choose the right swap. LNSwap has an open-source smart contract code you can vet before making decisions.

Participate in DeFi by Providing Liquidity

Liquidity pools form the backbone of DEXs by helping them keep trading efficiently. Becoming an LP is a great way for you to participate in the world of DeFi by putting your tokens to work.

If you’re looking to provide liquidity in the Bitcoin market and would prefer to participate to a greater degree by controlling nodes, LNSwap is the protocol for you.

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