Cryptocurrency liquidity providers play an important role in the trading of cryptocurrencies within a Decentralised Finance or DEFI market. These liquidity providers pour crypto-asset funds into a ‘pool’ that other traders can use to conduct cryptocurrency swaps on the platform. This function is conducted through the use of Smart Contracts. Providers can also generate a passive income based upon fees charged to users of the pool. DAI/ETH on Uniswap is one popular decentralized cryptocurrency exchange that uses a liquidity pool.
To best understand liquidity providers, it helps to have a strong grasp on how liquidity pools function. The purpose of a Liquidity Pool is to allow the trade of crypto assets on a decentralized exchange market. To set up the decentralized crypto exchange market the first liquidity provider will make an initial stake with their own crypto assets. This stake will be set at an equal rate between the two exchanging tokens. The purpose of this equal exchange rate is to prevent arbitrage.
This initial stake into the pool will earn the provider a fee of 0.3% in the form of a ‘provider token’ for each trade conducted on the platform based upon the strength of the liquidity pool. This incentivizes further stakeholders to invest into the pool, to gain a portion of the 0.3% fee. As more stakeholders grow the pool, more trades can be conducted of its strength. Thus creating a positive ‘feedback loop’ of users and providers.
After each successful cryptocurrency token exchange on the platform, a price adjustment will take place. Attempting to best represent the ongoing value of the tokens. This is conducted by a deterministic algorithm called an Automated Market Maker or ‘AMM.’ Different exchange platforms with different Liqiuidty Pools and Providers use different AMMs to adjust value and provide incentives for stakeholders. Some examples of these different AMMs are Curve, Uniswap, and Balancer.