Providing Liquidity — What does it mean and how does it work?
In this article, we will take a closer look at the concept of providing liquidity and the functioning of liquidity pools in the world of cryptocurrencies.
Before we talk about Liquidity Pools in-depth, let us take a quick look at some UniSwap statistics:
- In the last 24 hours, about $382.16k was generated as fees on Uniswap for the USDC-ETH liquidity pool. This fee would be distributed among those who hold the LP tokens for the USDC-ETH pair.
- At the moment of writing, the Total Value Locked into the USDC-ETH liquidity pool is of 295.61 Million USD
- In the past 7 days, the total USDC-ETH trading volume was of 810 Million USD
- The USDC-ETH liquidity pool on Uniswap charges 0.3% on every trade that reverts back to the liquidity providers.
There are hundreds of liquidity pools out there, other than USDC-ETH.
Holding a few of these LP tokens can provide a much higher ROI than by holding the LP tokens for the USDC-ETH pair. On some occasions, it can even offset daily losses from price depreciation.
Now that you have seen some interesting numbers, let us understand what the other associated jargon words mean — Liquidity Provider, Liquidity Pools — what they are and how they can be helpful to the users as well as the decentralized exchanges.
What/Who is a Liquidity Provider?
A liquidity provider, also known as a market maker, is someone who provides their crypto assets to a platform to help with decentralization of trading. In return they are rewarded with fees generated by trades on that platform, which can be thought of as a form of passive income.
It is important to note that the assets provided are locked with the platform for the amount of time the user decides to provide liquidity.
What is a Liquidity Pool?
The quantity provided by you would be in the form of a token pair, which are locked in smart contracts and are used to provide liquidity. The liquidity you provide is deposited into a liquidity pool, which is used in most cases, by decentralized exchanges. A liquidity pool is designated by the token pair it represents. For example, ETH-USDC is a liquidity pool that contains the liquidity provided for the token pair ETH and USDC.
Why do we need Liquidity Pools?
To better understand the concept of liquidity pools, we need to understand the concept of Automated Market Makers.
In a traditional trading system, we follow the order book model. Here is how it works:
- Buyers(Bidders) want to buy a particular stock/token for the lowest price possible.
- Sellers want to sell a stock/token for the highest price possible.
- The buyers and sellers come together to facilitate the trading.
But what happens when there aren’t enough buyers who want to buy a particular stock/token for a given price or there aren’t enough sellers to sell a particular stock/token for a given price?
This is where Market Makers come into the picture. Market makers are entities who are always willing to buy/sell assets, thereby providing liquidity and ensuring that users can always trade on the platform.
If you are with me so far, you are doing great!
Though we can replicate the traditional model of Order Book Exchange in the DeFi world, it would be quite expensive, slow, and result in a bad user experience. To solve these issues, we have the Automated Market Maker(AMM) protocol.
- In AMM, when a new pool is created, the first user who provides liquidity for a particular token pair sets the price of the token in the pool.
- In the case of Decentralized Exchanges like Uniswap, the Liquidity Provider needs to provide an equal value of both tokens.
- There is a smart contract that is created for each pair where the liquidity funds are deposited. These are also known as Liquidity Pools.
- As more people provide liquidity, it is ensured that users can buy/sell that asset by swapping it with other tokens for which the liquidity pair has been created.
- This creates an automated and fair market, instead of involving specific teams of people or algorithmic bots to create the market-making for us.
How do Liquidity Pools work?
Many businesses that are creating their tokens are heavily reliant on the concept of Liquidity Pools to ensure increased liquidity and circulation of their tokens. Providing liquidity for a new token by creating a token pair, is one of the processes involved in an IDO(Initial DEX Offering).
The answer to the question in this section can be figured out from the steps stated in the AMM protocol, but let us outline the brief steps here:
- When a new token pair is registered, a new market is created for that token pair. This creates a liquidity pool for this token pair, to which users can provide liquidity.
- Once the liquidity provider(LP) provides liquidity, they receive LP tokens representing the amount of liquidity they have provided.
- In DEX-es like Unsiwap, when a trade associated with a particular Liquidity Pool takes place, a 0.3% fee is charged on the trade, which is proportionally distributed among the LP token holders.
- And what’s more, you can withdraw your liquidity anytime you want, from the liquidity pools.
And voila! We are now familiar with how Liquidity Providers work and how it is useful for both Decentralized Exchanges as well as users who want to earn some side income by providing their crypto assets to liquidity pools.
At CardWallet, we will not be having our Liquidity Providers but instead, choose to integrate with popular pools like Uniswap, Sushiswap, Pancakeswap, etc. based on community voting.
Having a liquidity provider integration with CardWallet will ensure that our community members can use their crypto assets to the best of their ability, to maximize their revenue and minimize their losses.
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