Liquidity Provider
A liquidity provider (LP) is someone who deposits tokens into a liquidity pool so that others can trade against it. In return, the LP earns a share of the pool's trading fees, but also takes on the risk of price changes between the tokens.
What a liquidity provider does
On a decentralized exchange, trades happen against pools rather than against other traders' orders. Those pools only exist because LPs fill them. In a classic pool, you deposit two tokens in equal value, for example ETH and USDC, and receive LP tokens that record your share. Every trade pays a small fee, often a fraction of a percent, which is added to the pool and shared among LPs in proportion to their stake.
Newer designs, such as the concentrated liquidity introduced by Uniswap v3 in 2021, let LPs place their funds within a chosen price range. This earns more fees per dollar while the price stays in range, and nothing when it leaves it.
Impermanent loss, with numbers
Say you deposit 1 ETH and 2,000 USDC when ETH costs 2,000 USDC, a total of 4,000 dollars. ETH then doubles to 4,000. Arbitrage traders buy ETH from the pool until its price matches, and your share becomes about 0.707 ETH and 2,828 USDC, worth roughly 5,657 dollars. Had you simply held, you would have 6,000 dollars. The gap of about 343 dollars, roughly 5.7 percent, is impermanent loss. It shrinks if the price returns, and becomes permanent if you withdraw at the new price.
Why it matters
LPs make decentralized trading possible without banks or professional market makers. Whether being an LP pays off depends on whether the fees earned exceed the impermanent loss, which in turn depends on trading volume, the fee tier and how far the two prices drift apart.
Other risks
Pools for volatile or unknown tokens can lose value quickly, and scam tokens can drain them. Smart-contract bugs put deposits at risk. Advertised returns often include temporary token rewards, which can stop or lose value. Concentrated positions need active management and can earn nothing for long periods.
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Frequently asked questions
How do liquidity providers make money?
From a share of the trading fees paid by people swapping in their pool, and sometimes from extra token rewards offered by the protocol.
Why is it called impermanent loss?
Because the loss compared with holding disappears if prices return to where they were when you deposited. It becomes real once you withdraw at a different price.
Is providing liquidity to a stablecoin pair safer?
Two stablecoins pegged to the same currency move little against each other, so impermanent loss is small. The main risk then is one stablecoin losing its peg.
Related terms
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