What Does “Providing Liquidity” Mean?
The mechanism that paved the way for the flourishing of today’s DeFi industry.
TLDR:
- Liquidity pools are the backbone of most DeFi platforms today. They usually run on an algorithm called AMM (Automated Market Maker), and are executed by a smart contract.
- Impermanent loss is a normal occurrence for liquidity providers, but it can be covered by the profits earned from transaction fees paid by other users.
What does providing liquidity mean?
Providing liquidity is the act of placing one or more sets of tokens in a smart contract vault, called a liquidity pool, in order to support DeFi platform features such as lending, borrowing, swapping of coins, or more, and provide other users immediately available and liquid assets. It helps the platform to provide optimal user experience and remain decentralized, by not relying on one single third party or point of failure.
Liquidity pools are the foundation of most DeFi platforms. The liquidity, whenever you perform a transaction in a DeFi protocol, comes from these pools, provided by the liquidity providers, or also known as market makers.
In return, these providers habitually receive a Liquidity Pool (LP) token, acknowledging that you own a certain amount of liquidity in a specific platform, and which you need to return to the pool if you want to take your liquidity back.
What is the mechanism behind liquidity pools?
Liquidity pools run in an algorithm called AMM, or Automated Market Maker. This is directly in contrast with Order Books that most centralized exchanges use.
With Order Books, users must wait to have their limit orders get fulfilled. On a centralized exchange, you will normally see a list of buyers with their bid price, and sellers with their ask price, on a display.
For a sale to happen, the Order Book must match the sellers’ ask price with the buyers’ bid price, so it takes a while before a transaction happens.
With AMMs, orders get fulfilled instantly; thanks to the smart contract. The AMM model gets its liquidity from the pool, executed by an algorithm that sets token prices based on the current supply, so there is no need to wait for a counterpart that is willing to buy or sell.
The most common formula for AMM is x*y=k, where k is constant, while x and y are the two different tokens supplied in a liquidity pool.
What is the benefit of providing liquidity?
Liquidity providers earn an amount from every transaction that happens in the pool. This transaction fee is distributed to each provider, depending on the proportion of their stake.
It was mentioned previously that liquidity providers get LP tokens in return for providing assets in a pool. These LP tokens act like certificates that need to be present in your wallet whenever you want to take your liquidity back.
The LP tokens given to you can help you farm on another pool, which earns you another asset (usually a DAO or internal token), while your liquidity is on the main pool.
Any caveat?
Yes. Although liquidity providing can be an extremely profitable activity, there is one thing that sometimes prevents users to start mining: impermanent loss.
Impermanent loss happens when the value of the tokens you have deposited is less than the value when you have held them instead.
It is a concept that is not always straightforward to grasp at first sight. Here’s an example below.
For instance, let’s imagine you have deposited 50/50 ETH-USDT, at a price of 1,000 USD per ETH, and 1 USD per 1 USDT.
2 ETH: 2,000 USD (50%)
2,000 USDT: 2,000 USD (50%)
=4,000 USD VALUE (100%)
Let’s say the price of ETH increased to 1,200 per ETH. To maintain the 50/50 ratio, your ETH must give way, so its new ratio will be:
1.66 ETH: 2,000 USD (50%)
2,000 USDT: 2,000 USD (50%)
= 4,000 USD VALUE (100%)
vs when you held your ETH instead, it’s value will be:
2 ETH: 2,400 USD (at 1,200 per 1 ETH)
2,000 USDT: 2,000 USD
= 4,400 USD (difference of 400 USD from above example)
The impermanent loss is the 400 USD you have lost since you put your coins in liquidity, vs when you just held them.
In reality, most impermanent losses are easily offset by the earnings that you get per user transaction in the liquidity pool, and by the yield of the tokens you have farmed; so, it’s still profitable in the long run.
There are ways impermanent loss can be mitigated. One example is iGain IG (Impermanent Gain), where you buy a special derivative token called LONG token, to hedge your losses.
Conclusion
Providing liquidity has been a crucial part of the DeFi ecosystem, and it will only continue to evolve as the adoption of the blockchain grows.
To wrap it up:
- Liquidity Providers send out the crypto assets to a Liquidity Pool.
- The Liquidity Pool will send back LP tokens as an acknowledgment of deposit to the Liquidity Providers. The LP tokens need to be presented to the pool when you want to take your assets back (via your wallet).
- You will now start earning from every transaction that happens on that Liquidity Pool.
- In the mean time, the LP tokens can be put in a Farming Pool, so you can earn another token (this depends on the Farm).
