What does a liquidity provider actually do?
- Author
- CRYPTO PORT Editorial
- Published
- Updated
- Reading time
- 5 min
In short
A liquidity provider commits assets so that others can trade on demand. On order books that role falls to market makers; on decentralised exchanges it falls to anyone depositing into a pool. The fees they earn are payment for carrying price and inventory risk.
Key points
- Stands ready as the counterparty to other traders
- Different mechanics on books and AMMs, same function
- Paid mainly out of trading fees
- Always exposed to the assets' price movement
Definition
A participant that supplies the other side of trades — by posting orders on a centralised order book, or by depositing assets into a liquidity pool on an automated market maker.
On an order book, anyone who posts a limit order is providing liquidity; professional makers simply do it at scale and without pause. With no limit orders present, market orders either fill at absurd prices or do not fill at all.
AMM-based decentralised exchanges work differently. Providers deposit a pair of tokens into a pool, and a formula sets the price against those balances. Traders swap against the pool, and the fees they pay are distributed to depositors. No individual quoting is needed, but the pool's composition rebalances automatically as prices move.
Either way, the reward only arrives when trades happen. With no trading there are no fees, while the deposited assets keep moving in price. On an AMM there is also the gap against simply holding, known as impermanent loss. A headline yield alone is not enough to judge the position.
Watch out for
- · Advertised APRs are estimates from past fee income, not a promise of future payouts
- · On an AMM, impermanent loss can leave you worse off than simply holding
- · A flaw in the pool's contract can cost you the deposited assets outright