What is a liquidity provider?

Imagine a currency exchange office with no euros or dollars in the till: how would it serve the next customer? Likewise, many decentralized exchanges (DEXs) need tokens available for users’ swaps. These are supplied by liquidity providers, also known as LPs.

In DeFi, a user deposits tokens into a liquidity pool managed by a smart contract. For example, in a typical ETH and USDC pool, they deposit both in equal initial value. When someone swaps USDC for ETH, they add the former to the pool and take out the latter. The automated market maker (AMM) calculates the swap according to its rules.

On many protocols, the depositor receives LP tokens that represent their share of the pool. When withdrawing, they return or redeem them for the assets they’re owed. Not all systems use the same model: some record the position as an NFT, especially when liquidity is provided within a specific price range.

Why it matters

For anyone making swaps, the available liquidity affects the execution price. In a shallow pool, a large trade can move the price sharply. LPs help swaps happen with less price impact, depending on the mechanism and the available liquidity.

For the provider, the reward is usually a share of the trading fees and, on some protocols, extra token rewards. We think the distinction is essential: this income doesn’t amount to guaranteed profit, nor to interest on a bank deposit.

What to watch out for

The ratio of tokens in your position changes as swaps take place. So you may end up with a lower total value than you would have had by simply holding the original tokens in your wallet. This difference is called impermanent loss, and fees don’t necessarily cover it.

There’s also the risk of a bug in or a hack of the smart contract, as well as the tokens themselves losing value. In positions with a specific price range, when the market moves out of range, the position usually stops earning fees until the price returns or the position is adjusted.