What Is A Liquidity Provider?
A liquidity provider uses its digital assets to fund a liquidity pool that enables a decentralized exchange to function. A liquidity pool is an accumulation of digital assets locked in a smart contract. Liquidity pools are essential for the smooth functioning of a blockchain. It enables traders on a blockchain to enter and exit trade positions even on pairs that would otherwise have low liquidity.
Liquidity providers are provided with earning opportunities when they add their funds to liquidity pools. They earn from transaction fees paid by traders, and the fraction given to each provider is dependent on the fraction of the entire collection from the provider. Liquidity providers face the risk of temporary loss when they put their assets into liquidity pools. This occurs with a sudden rise in the price of assets. This loss is temporary because the loss can be recovered depending on price direction and fluctuations. However, the loss becomes permanent if the liquidity provider withdraws funds from the pool before allowing it to bounce back. Another risk faced by liquidity providers is the common occurrence of errors in liquidity pool codes. Hackers usually take advantage of these errors to steal funds from liquidity pools.
You can join a liquidity pool by creating an account with any platform of your choice. You will need to connect with a wallet that is smart chain enabled. After choosing the pair you want to deposit your funds into, you will ensure that you have enough of the two assets involved. Lastly, you will deposit your assets and get your Liquidity Provider tokens. Liquidity Provider Tokens indicate the amount of liquidity provided. When a transaction is made, a transaction fee is charged and distributed proportionally among the liquidity providers. For example, if you provide 5 percent of the total liquidity on a platform and the platform charges a 0.2 percent commission on each transaction, you get 5 percent of the 0.2 percent fee on the transaction.
Liquidity Provider Example
The process of joining the liquidity pools of different networks differs slightly from platform to platform but they are usually very similar to this. Examples of common liquidity pools are Uniswap, Curve Finance, PancakeSwap, Bancor, Kyber Network, SushiSwap, Balancer, and Convexity Protocol.
John wants to become a liquidity provider in the Uniswap liquidity pool. He, therefore, gets hold of ETH and Dai (an ERC-20 token) in equal amounts. John then uses these tokens to join the liquidity pool. He is now a liquidity provider; his funds are now locked.« Back to Glossary Index