What is Liquidity Provider in DeFi?

Before explaining what a liquidity provider is, it is essential to first know what the term “liquidity” stands for in crypto. 

In a nutshell, liquidity means the ease of converting an asset to another without affecting its underlying price. 

In traditional finance, fiat is the most liquid. This is because fiat, for example, the USD or Yen, can easily be exchanged for other assets such as gold, government bonds, crypto, stocks, etc. Most importantly, it is backed by the government and is considered legal tender.

In crypto, Bitcoin is the most liquid crypto asset because it is listed on all major cryptocurrency exchanges, commanding a bigger share of the sphere’s market cap.

On the other hand, Ether (ETH) is the most liquid crypto asset in Decentralized Finance (DeFi) because most trustless finance projects deploy on Ethereum.

Now that the concept of liquidity is explained, the term “liquidity provider” will be easy to understand.

What is a Liquidity Provider?

A Liquidity provider is an investor or crypto holder who deliberately stakes their assets on DeFi platforms, mostly DEX, to earn passive income through transaction fees. 

Liquidity providers on top DEX platforms such as Uniswap, for instance, will receive 0.30 percent of trading fees depending on the trading volumes on the pool. To incentivize participation and to ensure a pool’s liquidity is deep, transaction fees are distributed depending on the amount of liquidity available and trading volumes in the liquidity pool. 

At the same time, fees are distributed proportionally to the amount of liquidity provided. Therefore, the more assets a liquidity provider locks in a pool, the higher the income.

With this knowledge, it is also important to add how a liquidity provider (LP) token works.

How Does Liquidity Provider (LP) Tokens Works

In DEXes, liquidity (LP) tokens prove that you are part of a liquidity pool. Fees accrued from trading activity are accumulated in a liquidity pool. Afterward, the protocol automatically distributes fees earned to liquidity providers.

Since we have been talking about liquidity pools, an explanation of that aspect must be made to ensure complete comprehension of what liquidity provider tokens entail.

What is a Liquidity Pool?

A liquidity pool refers to the total funds locked in the DeFi protocol’s smart contracts. Depending on the protocol’s purpose, these smart contracts will ensure that trading, lending, etc, are smoothly executed as intended. Because of the rising popularity and how revolutionary the innovation has been, the liquidity pool model is considered the cornerstone of DeFi. 

In return for making their funds available in the pool, liquidity providers receive a share of trading fees earned for every trustless event in DEXs.

Bottom Line

As there are rewards to becoming a liquid provider, there are also risks involved. One of such risks is that once you have entered your funds into a liquidity pool, a smart contract controls it. There is no custodian or central authority. Therefore, your stake may be lost forever in case of a bug. This is besides the risk of impermanent loss for liquidity providers since there could be fluctuation in asset value at the end of the staking period, leading to losses.