Overview

In Web2 trading, centralized exchanges use order books, where buyers and sellers place bids and asks, and trades are matched by the platform. Liquidity comes from market makers and large investors, while traders rely on the exchange to process transactions and hold their funds.

In Web3, traders swap assets directly against a liquidity pool, which refers to a “pool” that holds two or more assets (e.g., ETH/USDC) on a decentralized exchange (DEX). Instead of order books, prices are determined algorithmically.

Liquidity provision refers to the process of depositing assets into a liquidity pool, enabling trading on DEXs. Liquidity providers (LPs) supply two assets (e.g., ETH and USDC) and, in return, earn a share of trading fees generated by swaps in the pool.

Unlike traditional exchanges that require buyers and sellers to match orders manually, DEXs use smart contracts to price assets algorithmically based on supply and demand within the pool.

Key terms relating to liquidity provisioning include:

  • Liquidity Provision: The act of providing tokens to a DEX liquidity pool to facilitate trading.
  • Liquidity Pool: A smart contract holding two or more tokens that traders swap between.
  • Algorithmic Market Maker (AMM): A smart contract-based trading mechanism that determines asset prices and enables decentralized trading.
  • Arbitrageurs: Traders who exploit price differences between liquidity pools and other markets to profit while maintaining price stability.

How Liquidity Provisioning Works

Instead of using order books, DEXs rely on AMMs to determine prices dynamically. When traders swap one asset for another, the ratio of assets in the pool changes, affecting the price.

For example, in a BTC/USDC liquidity pool, if many traders buy BTC with USDC, the BTC supply in the pool decreases while USDC increases, causing the price of BTC to rise relative to USDC. This dynamic ensures that liquidity is always available and that prices adjust in real time based on market activity.

Here’s how this might work:

  • Liquidity Providers (LPs) Supply Assets: Those who deposit assets into the pool are called LPs. They receive LP tokens, representing their share of assets in the pool.
  • Liquidity Pools Adjust Pricing Algorithmically: The AMM ensures that as one asset is bought, its supply in the pool decreases, raising its price relative to the other asset.
  • Arbitrage Keeps Prices Aligned: If the price of an asset in a DEX pool differs from another pool or a centralized exchange (CEX) like Coinbase, arbitrage traders step in to buy the underpriced asset and sell it elsewhere, helping align prices across markets.

Why Provide Liquidity?

Liquidity provisioning is popular as it allows users to earn passive income by depositing assets into a DEX liquidity pool. In return, liquidity providers (LPs) receive a portion of trading fees generated by swaps in the pool. Some platforms also offer additional incentives, such as yield farming rewards, governance tokens, or boosted APRs for providing liquidity to specific pools.

That being said, liquidity provisioning carries risks.

One major concern is impermanent loss, which occurs when the price of deposited assets changes significantly compared to when they were first added to the pool. If the price of one asset rises or falls sharply, LPs may end up with more of the lower-value asset and fewer of the higher-value asset when they withdraw, potentially resulting in lower returns than simply holding the assets outright.

Additionally, DEX smart contracts are not risk-free, as exploits or vulnerabilities in the code could result in funds being lost or stolen.

For these reasons, liquidity providers must carefully select pools, monitor price movements, and assess potential risks before depositing their assets.

Liquidity Provisioning Key Considerations

Key considerations relating to liquidity provisioning include:

  • Earn Passive Income: LPs earn a portion of trading fees generated by swaps in the pool.
  • Impermanent Loss Risk: Occurs when the price of deposited assets changes compared to when they were first added to the pool.
  • Smart Contract Risk: Although major DEXs like Uniswap are considered secure, they still have inherent smart contract risks.

Popular Liquidity Provisioning Platforms

A few popular liquidity provisioning platforms include:

  • Uniswap: A popular, long-standing DEX that operates across 30+ networks. Their V4 upgrade introduced “Hooks” which provide developers with more customization over DEXs, including the ability to introduce new trading strategies.
  • PancakeSwap: A leading DEX on BNB Chain that’s also 7+ other networks, offering low-fee trading, yield farming, and lottery-style rewards through its native CAKE token.
  • Raydium: A Solana-based DEX and AMM that provides high-speed, low-cost swaps, concentrated and constant product liquidity pools, and permissionless yield farming.