What are Liquidity Providers and How Does It Work?

Liquidity in cryptocurrency is the ability of a coin to be converted into cash or other coins. In financial markets, liquidity generally describes the ease of converting assets into cash without difficulty. And other conversions into coins into cash or other coins in the context of liquidity in cryptocurrencies. This is certainly an important concept when dealing with cryptocurrencies.

A user who funds a liquidity pool with crypto assets they own to facilitate trading on the platform and earn passive income on their deposit is what a liquidity provider is. They stake their cryptocurrency tokens on Decentralized Exchanges (DEXs) to earn transaction fees, often referred to as liquidity mining or market-making. The amount of available liquidity and the number of transactions in the liquidity pool that affect interest rates, making the denomination of interest rates in fees vary.

For example, a liquidity provider contributes $10 USD worth of assets to a liquidity pool that has a total value of $100, the liquidity provider will receive 10% of the liquidity pool tokens. 10% of tokens received by the liquidity provider is the 10% they owned in the liquidity pool of the crypto.

Decentralized exchanges (DEXs) are available in blockchain smart contracts used for liquidity pools that use an Automated Market Maker (AMM) system. The smart contracts used have to follow some standards; the most widely used standard is the ERC20 standard, which requires an approved function and a transfer from function. This allows the trading of illiquid trading pairs with limited slippage. Exchanging illiquid trading pairs on book-based exchanges (or, a Centralized Exchange) can result in losses and difficulty executing trades, but trades can always be executed as long as the liquidity pools are large enough with a liquidity provider in place. AMM also operates automatically which supports decentralization and fairness.

To collect liquidity on the DEX, liquidity providers use their blockchain wallets (Ethereum wallet, VexWallet, etc.) to send tokens to the liquidity pool. Liquidity providers do not frequently move their assets across different pools, seemingly indifferent to price changes or other market indicators. Liquidity providers are thus seen as trade facilitators and are paid an activated transaction fee for their trades.

Basically, liquidity providers work using tokens as proof that the liquidity providers own part of the liquidity pool which can be used to remove their crypto tokens from the liquidity pool at any time. The fee transaction that earned directly went to the liquidity pool for proportionate growth of the liquidity pool. “Fee-earning limit order” is the protocol that explains the liquidity providers will be removed from the liquidity pool by smart contract and sell the liquidity provider’s cryptocurrency for whichever token is still within your price range if the price of the cryptocurrency falls out of the price range you specify.

Let’s take the case, the liquidity provider provides $1,000 and $2,500 in the liquidity pool. However, the liquidity provider’s token drops to $1,000, then they will sell their DAI for their token and receive all their funds back from the token they used. This can mean, by adjusting the range of liquidity prices provided by liquidity providers, they can also adjust their liquidity to market conditions.

But, on a research paper by Capponi and Jia (2021) found that there is a unique equilibrium prevailing between the incentives of liquidity providers and characterize the subgame perfect equilibrium of the game, i.e. liquidity providers are willing to deposit their tokens into the AMM or also known as “adoption equilibrium” and where liquidity providers do not deposit their tokens into the AMM or “liquidity freeze equilibrium”. This analysis sheds insights on what type of tokens are most suitable to be traded on the AMM: (1) stable coins that are not subject to large price fluctuations, and (2) tokens for which investors have high personal use.

Ye Wang et al (2021) in their paper stated most liquidity providers reserve their money only in one liquidity pool until September 2020. Later on, during October and November 2020, liquidity providers are interested in more pools. The largest providers participate in 120 pools and more than 96.5% of the accounts reserve their money in no more than 5 pools.

Distribution of the number of liquidity pools that each liquidity provider participates in. About 10,000 only participate in a single pool (top left), and some providers participate in many pools (bottom right) (Ye Wan et al, 2021).

The existence of liquidity in the marketplace is important because it can create an equilibrium price for buyers and sellers in the marketplace so that it can be accepted by everyone, ensuring also that prices are stable and not vulnerable to changes in trading results that can trigger volatility and risk for the general market, as well as increasing liquidity. The accuracy of technical analysis and the formation of liquid charts develops precisely. In other words, the fundamental of Decentralized Finance (DeFi) is liquidity.  [  ]

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