Liquidity Provider is a term used by investors in the crypto market. Investors need to know the term, among other things, to succeed in the market or trade in the best possible way.
Initially, cryptocurrency exchanges used centralized methods to record users’ transactions. But over time, blockchain specialists sought ways to decentralize transactions. That is to say, users do not need intermediaries to invest and trade cryptocurrencies.
Decentralized exchanges, or DEX, benefits users and traders so that users can trade cryptocurrencies completely anonymously and without intermediaries, earning tremendous advantages.
One of the main differences between centralized and decentralized exchanges is that centralized exchanges will require liquidity providers to conduct transactions. Given that many people are not familiar enough with this concept, this article will address the issue of what is a liquidity provider.
Providing liquidity in centralized and decentralized exchanges
Centralized exchanges use a system for matching orders, called the Matching Engine. The matching engine makes it possible for exchanges to place orders that match each other in terms of price and volume of transactions, and to record transactions.
Using the matching engine, complex financial markets can be provided in centralized exchanges. But because the matching engine can only be implemented on centralized platforms, another method must be used to record transactions in decentralized exchanges.
The idea of using a matching engine has been tested many times in decentralized exchanges. But the main obstacle there was the necessity of recording new transaction information entirely on the blockchain network. This dramatically increases the cost of registering transactions and users must pay a huge fee to make a simple transaction.
There are other reasons why it is not possible to use the previous systems in decentralized exchanges, including the exclusion of users in the exchange’s profits. Regarding all these, most of the new decentralized exchanges use a different system for recording transactions, called the automated marketing system.
In decentralized exchanges based on an automated marketers system, users enter into a transaction with the exchange itself by registering a buy or sell order. And the required cash is paid from the liquidity pool. Therefore, whenever users register new orders, their transactions are done in a non-peer-to-peer manner, which has certain advantages, one of the most important of which is the significant reduction of liquidity by exchanges.
But you may be wondering where the liquidity pools get their liquidity from. This is where you need to know what a liquidity provider is. And what is its use in DeFi?
Who is the liquidity provider?
In short, the Liquidity Provider is the person who gives his liquidity to the liquidity pools.
While many people think that liquidity pools are only used to provide liquidity for the automated marketing system, they also have other applications like lending that are currently used in many DeFi applications. Therefore, the liquidity provider will not only invest in decentralized exchanges but also provide the necessary capital for various DeFi platforms
Benefits of providing liquidity
There are various benefits to providing liquidity, and those who invest in liquidity pools will receive a variety of benefits. All liquidity providers on different platforms will share in the transaction fee to the extent of their capital. For example, in some exchanges, users can receive 0.25% of the transaction fee for the capital they have invested in the pool.
Imagine someone registering a thousand-dollar deal in one of the decentralized exchanges. If the transaction fee is 0.5 percent, something around $ 5 of the transaction amount will be considered as a fee, of which 0.25 percent will be approximately $ 1. Assuming you own 10 percent of the exchange pool, you will earn 10 cents from just a thousand-dollar transaction by exchange users, which will be a significant figure in the long run.
Providing Liquidity risks
If you are planning to invest in liquidity pools as a liquidity provider, you must first know what the risks of participating as a liquidity provider are and what problems liquidity suppliers may experience.
One of the biggest issues that liquidity providers may face is the risk of Impermanent Loss.
The impermanent loss will occur when the price of a liquidity token has fallen relative to the time you purchased it. It is good to know that pools with more assets are more prone to sudden losses, so this should be considered before investing in pools.
Although bugs and errors in liquidity pools are rare and almost impossible on reputable platforms, users should be aware that creating any bugs and errors in smart pool contracts will put their capital at risk. And since it is not possible to retrieve it, the best way is to not invest in new projects or projects that are not credible enough.
The best liquidity provider platforms
Among the various platforms available in this field, Uniswap is one of the best and most reputable options based on Ethereum, which individuals can choose to invest as a provider of liquidity. Using Uniswap exchange, users can register their transactions with full possession of assets and without the need for authentication. The low cost of transactions and access to the latest tokens have made Uni Swap one of the best choices for cryptocurrency trading.
Liquidity providers are one of the main players in the DeFi sector, and without them, many platforms will face various problems. Liquidity providers will not only receive significant profits by providing the liquidity needed for existing platforms but will also enable many platforms to survive.