What Is a Liquidity Provider?

Liquidity refers to the ease at which an asset such as Bitcoin, Ethereum, or other altcoins are convertible to a more acceptable form such as cash. Cash is high-powered money in economics because it is generally acceptable and can be converted to other forms of desired assets at the lowest possible cost. Hence, cash in paper money and coins is considered the most liquid asset.

Liquidity providers are large firms like brokerage institutions that create buy and sell orders on their accounts or inventory. These firms buy a currency or stock for a certain amount and sell the same stock or currency at a marginally higher price.

Liquidity providers are an important element of DeFi and cryptocurrency exchanges. Centralized cryptocurrency exchanges borrow from the traditional market maker model to enable trades anytime. Liquidity providers can be recognized firms or individuals on centralized exchanges. These exchanges use a liquidity pool model similar to automated market makers (AMM).

The most popular liquidity providers in the crypto space are traders adding funds to pools on decentralized exchanges based on the AMM models. Most definitions of liquidity providers in DeFi and crypto often focus on AMM because of the success of exchanges based on this model (e.g., Uniswap).

In an AMM model, liquidity providers add their funds to a pool, but the market is made automatically using a constant product market maker function x × y=k. The formula means that the value of the funds in the pool must remain stable at value k, which is a multiple of x and y. The AMM model balances itself out, and the slippage resulting from the transaction is also computed automatically. However, AMM offers the opportunity for traders to make profits by arbitraging between the pool and centralized or other decentralized exchanges. Doing this balances out the pool, and the pool will remain balanced as long as there is this opportunity for profits.

Summary of Important Points

• Liquidity describes how easy it is to move between assets and is determined by the cost of exchanging the held cryptocurrency or asset for other assets.
• It is less expensive to move a liquid asset such as cash from one form to another or exchange the crypto for other cryptocurrencies.
• DeFi borrowed the idea of providing liquidity to facilitate trades from traditional financial setups like the stock and forex market.
• AMMs are the most popular form of liquidity provider setups on decentralized exchanges, and they allow liquidity providers to facilitate trades and share in the fees.
• Slippage is the difference between the price of assets in a trade and the price at which the trade was executed.
• Liquidity providers in crypto can be firms or individuals, although firms can pool a larger share of investment funds.
• Yield farming in DeFi is an offshoot of liquidity provision on decentralized exchanges and the higher incentives offered for providing liquidity for illiquid pairs.

Types of Liquidity Providers

Yield Farmers

Yield farmers are individuals or other entities that add funds to liquidity pools on decentralized exchanges to maximize the profit paid in fees or incentives. Yield farmers are the highest liquidity providers on decentralized exchanges by number. Typical yield farmers are primarily interested in the rewards from the liquidity pools they invest in. There is also no barrier to becoming a yield farmer, which accounts for many farmers.

Yield Aggregators

Yield aggregators are like decentralized institutions that pool crypto assets of their investors into an algorithm that invests in the most profitable liquidity pools on their behalf. The legendary Andre Cronje popularized the setup through the Yearn Finance project, which launched during the DeFi Summer. Yearn Finance was a huge success and later allowed the deployment of new optimization models for yield farming. Yield aggregators like Convex Finance, Alpaca Finance, Arrakis Finance, Tulip Protocol, and Tokemak offer attractive interest rates.

Exchanges

Centralized exchanges offer a marketplace with high liquidity to facilitate trading and exchanging one asset for another between users. Some of the biggest exchanges like Binance, Huobi, and Coinbase enjoy a large user base and are often the source of large liquidity for their users. These exchanges build their business around their users. Some exchanges like Binance and Huobi offer direct liquidity farming to their users.

Institutional Market Makers

Institutional market makers like Wintermute, GSR, Altonomy, and B2C2 USA work like traditional market makers in the forex market or stock exchange. They make a market on both exchanges and OTC and facilitate risks within the cryptocurrency space. Most institutional crypto liquidity providers are increasingly working with algorithms to make better decisions on what transactions to make and the safest way to manage investor funds.

Factors to Consider When Choosing a Liquidity Provider

Market Depth

The ability of the market to take in large orders without significant price impact is known as market depth. Individual and institutional liquidity providers must consider the risks inherent in the volume of buying and selling orders on an asset to stay profitable. Higher market depth means that the security in question can easily convert to other assets. It can help market makers decide on their trades' volume and inform allocative decisions.

Risk Management

Risk management is a crucial part of liquidity providing or market-making. It is important to match risks properly against the potential profits or interest before providing liquidity. A risk-reward ratio of 2:1 is usually a fair management strategy for such transactions to ensure breakeven or profitability.

Regulation

Unlike traditional finance, the cryptocurrency market is fast-paced and hard to bring under perfect regulations. Regulating cryptocurrencies is incredibly complex because of the decentralized nature of most coins and tokens.

Model and Strategy

For individual investors, the model is the strategy for yield farming or liquidity provision, and it is important for healthy and profitable investments. The same goes for institutions that may use technical, fundamental, and algorithmic strategies to stay profitable.

How Liquidity Providers Make Money

Institutional liquidity providers make money from the difference between the buying and selling price of the cryptocurrency asset they trade. The profit is known as the bid-ask spread. Yield aggregators optimize the best strategies to determine which pools are the most profitable.

Like yield farmers, DEX aggregators make their money from fees paid by those who swap assets in those pools, along with the liquidity tokens of the issuing protocol. Although all liquidity providers try to avoid risk, impermanent loss, low or no spread, and volatility are the biggest risks for liquidity providers.