What does it mean to provide liquidity?
Providing liquidity is the process of storing one or more sets of tokens in a smart contract vault, known as a liquidity pool, to support DeFi platform functions such as lending, borrowing, coin exchanging, and more, and to offer other users immediately available and liquid assets.
By not relying on a single third party or point of failure, it allows the platform to provide an optimal user experience while being decentralized.
Most DeFi platforms are built around liquidity pools. When you complete a transaction in a DeFi protocol, the liquidity comes from these pools, which are provided by liquidity providers, also known as market makers.
In exchange, these providers usually receive a Liquidity Pool (LP) token, which indicates that you own a particular quantity of liquidity on a given platform and that you must return to the pool if you wish to withdraw your liquidity.
What is the underlying mechanism of liquidity pools?
AMM, or Automated Market Maker, is an algorithm that manages liquidity pools. This is in stark contrast to the Order Books used by the majority of centralized exchanges.
Users must wait for their limit orders to be completed while using Order Books. On a centralized exchange, a display will typically show a list of buyers with their bid price and sellers with their ask price.
To complete a transaction, the Order Book must match the sellers’ ask price with the buyers’ bid price, which takes time.
Orders are completed instantly with AMMs due to the smart contract. The AMM model obtains liquidity from the pool, which is managed by an algorithm that determines token values based on current supply, eliminating the need to wait for a counterpart eager to buy or sell.
The most commonly used AMM formula is x*y=k, where k is a constant and x and y are the two separate tokens available in a liquidity pool.
What are the advantages of providing liquidity?
Every transaction that occurs in the pool earns liquidity providers money. This transaction charge is divided among the providers in proportion to their investment.
As previously stated, liquidity providers receive LP tokens in exchange for contributing assets to a pool. These LP tokens function as certificates that must be present in your wallet if you want to reclaim your liquidity.
While your liquidity is on the main pool, you can use the LP tokens to farm on another pool, earning another asset (typically a DAO or internal token).
Is there a catch?
Yes. Although providing liquidity can be a highly profitable business, there is one factor that occasionally discourages consumers from starting mining: impermanent loss.
Impermanent loss occurs when the value of the tokens deposited is less than the value of the tokens retained instead.
But a good thing, most impermanent losses are readily offset by the earnings per user transaction in the liquidity pool, as well as the yield of the tokens farmed; hence, it remains lucrative for investors and providers in the long run.
