When exchanging tokens on crypto exchanges, the speed, price, and efficiently of your transactions always depend on the market’s liquidity. What stands behind liquidity? And who is there on the other side of your trade? This article explains the difference between liquidity provider vs market maker and the concept of liquidity pools.
What is Liquidity in Crypto?
Liquidity is the ease with which tokens or coins can be exchanged without significantly impacting their market price. Central to managing liquidity in both centralized exchanges (CEXs) and decentralized finance (DeFi) platforms are market makers and liquidity providers. Though they play similar roles, their mechanisms are different.
Market makers are usually firms or high-frequency traders that participate in a market-making platform to commit to buying and selling assets at quoted prices, thus ensuring the market remains liquid. They profit from the spread between their buy and sell assets, providing a continuous flow of transactions that help stabilize asset prices.
In the DeFi ecosystem, liquidity providers (LPs) are individuals or entities that deposit their assets into liquidity pools. These pools facilitate token swaps on automated market maker (AMM) platforms without the need for traditional buyers and sellers. LPs earn transaction fees generated from trades executed within the pool. Their earnings depend on their share of the pool’s total assets.
The fundamental difference lies in the execution. Market making in cryptocurrency implies active participation in the market, placing orders into order books, and profiting from spreads. LPs contribute to a collective pool, earning passive income from trade fees, with the pool’s algorithm determining prices.
What is a Crypto Liquidity Pool?
A liquidity pool is a digital pool of cryptos locked within a smart contract that supports decentralized trading. These assets serve as the foundational liquidity to execute trades for anyone wishing to swap one token for another within this DeFi framework.
The concept of liquidity pools brought a significant change in the decentralized exchange models, which previously relied on order books. The order book model face challenges, notably the high transaction costs incurred during trade execution. This made trading not only costly but also inefficient for market makers and other market participants.
Liquidity pools present a solution to another critical issue facing decentralized exchanges: the limitation of blockchain technology in handling high-volume transactions quickly. Given the multi-billion dollar scale of daily trades, blockchains’ slower transaction speeds were a bottleneck. Liquidity pools come as a strategic innovation, offering a more efficient, cost-effective, and scalable model for decentralized trading.
What is a Liquidity Provider?
A liquidity provider is an individual or entity that contributes assets to a DeFi pool, supporting the ecosystem by enhancing its liquidity. While initial funding often comes from the pool’s founders, over time everyday users may choose to invest too.
What does a liquidity provider do? An LP must supply equivalent values of both assets in a trading pair, such as supplying both Bitcoin (BTC) and Ethereum (ETH) to a BTC-ETH exchange pool. In return for their service, liquidity providers earn a fraction of the transaction fees generated by the trades occurring within the pool. Typically, a DeFi platform may impose a transaction fee, which is then proportionally divided among the liquidity providers according to their stake in the pool. Thus, if a cryptocurrency liquidity provider owns 15% of the pool’s liquidity, they would collect 15% of the accumulated transaction fees.
How Does a Liquidity Pool Work?
Liquidity pools function as decentralized marketplaces where pairs of assets can be exchanged by participants. Consider the pairing of Bitcoin (BTC) and a stablecoin like Tether (USDT) as an example. LPs are required to deposit both assets in the pair in proportionate amounts based on their current market value.
How does liquidity providing work? For instance, if a liquidity provider decides to contribute to the BTC/USDT pool, and the current value of 1 BTC is equivalent to 70,000 USDT, they must ensure that the value of the BTC and USDT they deposit matches this ratio. If the provider wishes to deposit 10 BTC, they must also deposit 700,000 USDT to maintain the required balance.
Pools enable users to swap one asset for another seamlessly. Let’s say a trader wants to purchase 5 BTC using USDT. To execute this trade, the trader sends the equivalent amount of USDT (based on the current value of BTC in the pool, say 70,000 USDT per BTC, totaling 350,000 USDT) to the liquidity pool. In exchange, the trader receives 5 BTC. This mechanism allows for efficient trading without the need for traditional market makers or order books.
Liquidity is a crucial concept in the crypto market that ensures trades are executed swiftly and efficiently. A crypto liquidity provider is a market participant who manages liquidity in crypto exchanges. Liquidity pools have revolutionized decentralized trading by offering a more efficient and scalable model that removes high fees and low throughput of transactions on exchanges.
