What is a Crypto Liquidity Provider? (How To Make Money with LP)

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By Kate
Estimated reading: 9mins
crypto liquidity providers

Crypto liquidity providers are crucial for DeFi to function properly. They stake digital assets in liquidity pools and thus support traders who perform buy and sell orders.

At this, they earn a share of transaction fees that users pay while exchanging funds within these pools. Thanks to smart contracts, the process is fully automated and devoid of central-party risks.

As a decentralized lending protocol, Liquid Loans offers such an option to its users, too.

Want to become a crypto liquidity provider yourself? Read on to find out how the process works, what risks it bears, and what Liquid Loans does in order to make the system secure.

Key Takeaways

  • Liquidity providers stake their digital assets in liquidity pools facilitating the trades and earning rewards in accordance with the size of their deposits.
  • At the time of writing, centralized exchanges represent the largest liquidity providers in the whole crypto market. Yet, some decentralized solutions have emerged as well.
  • If you want to become a liquidity provider you may consider such DeFi platforms as Uniswap, PancakeSwap, or PulseX.
  • Liquidity provides get LP tokens for contributing their assets to the pools. These tokens help them track their earnings and maintain control over their collaterals.
  • Some of the key risks that liquidity providers are exposed to include impermanent loss, counterparty risk, and smart contracts’ vulnerabilities.
  • With Liquid Loans, one can make predictable income by staking an overcollateralized stablecoin USDL in the Stability Pool.

What is a Crypto Liquidity Provider?

Crypto liquidity provider, also known as an Automated Market Maker (AMM) is an entity or an individual who provides digital assets to decentralized platforms

By staking cryptocurrencies in liquidity pools, a liquidity provider (LP) facilitates the trades within these pools. Users can buy and sell any of the supported assets with ease within these pools.

Traders can exchange their coins for ethers and other liquid assets. Thus, liquidity providers resolve the problem that was inherent to the early versions of decentralized exchanges (DEXes), i.e. the lack of liquidity.

Where to Provide Liquidity in DeFi

The best places to provide liquidity in DeFi are decentralized exchanges. Below, we have listed some of the options to consider if you want to become a liquidity provider.

1. UniSwap

Link: uniswap.org

Being the first DEX to introduce cryptocurrency liquidity pools, UniSwap represents one of the most popular decentralized marketplaces for buying and selling crypto assets.

It has an important limitation, though. It focuses on the Ethereum network only and doesn’t implement any solutions to reduce transaction fees which makes it a rather costly solution.

Besides, UniSwap experienced a few hacks in the past. Thus, in April 2023, it lost over $25 million USD due to a successful sandwich attack. Developers took quick action to fix the bug then.

Earlier in 2022, AMMs fell victim to a phishing attack that resulted in a total loss of 4,295 ETH worth $4.7 million. Neither of the hacks had any serious impact on the platforms’ liquidity, though.

2. PancakeSwap

Link: pancakeswap.finance

PancakeSwap applies the same principles as Uniswap does, but focuses on the Binance Smart Chain (BSC) instead. 

Thanks to the underlying blockchain, trade execution is much faster. Transaction costs are lower, too (flat 0.25% on every trade).

Yet, since BSC is mostly centralized, users should be aware of the potential counterparty risks. FTX crash in November 2022 has proved that not even the largest and most reliable providers can be trusted.

3. PulseX

Link: pulsex.com 

PulseX runs on the PulseChain that represents a Uniswap fork. Yet, it comes with a few additional perks and features. 

To combine liquidity from different blockchains, it implements bridges that make it possible to stake not only ERC20 tokens.

Also, PulseChain reduces transaction fees down to $0.01 per transaction. At the same time, it only takes 3 seconds for transactions to confirm. Built on top of Ethereum, it inherits its decentralization and high security standards.

How To Become a Liquidity Provider

To become a liquidity provider, all you need to do is to deposit some amount of digital assets into a liquidity pool that you prefer.

The good news about DeFi liquidity providers is that you don’t need any special license for that. Unlike forex and other TradFi markets that impose specific requirements for their participants, investors can make passive income regardless of the size of their deposit and their geographical location.

The process may slightly vary depending on the platform your choose. Yet, the basics remain the same:

  1. Select a DeFi platform and a liquidity pool that you want to join.
  2. Connect your wallet and grant it required permissions for the app to work with it properly.
  3. Make sure that you have a sufficient amount of assets in your wallet. Some pools have thresholds for minimum deposits.
  4. Create a new position in the selected pool. 
  5. Select the pair of tokens that you want to deposit and the preferred fee you want to earn.
  6. Put in the sum that you want to contribute and confirm the transaction in your wallet.

That’s it. Now you can watch rewards being accumulated in your account.

Also, don’t forget about other associated fees. Some liquidity pools charge additional commissions for deposits and withdrawals that may have a negative impact on your final yield.

Biggest Liquidity Providers

Biggest liquidity providers

In the early years, CeFi solutions were dominating the crypto market. Viable DeFi solutions emerged only in 2020 upon the introduction of liquidity pools.

At this, it comes as no surprise, that centralized crypto exchanges still hold the top positions as liquidity providers. Some of the most popular platforms include the following:

  • Binance
  • Kraken
  • Huobi
  • Coinbase
  • BitMEX

On such platforms, the market makers, takers, and order books determine asset prices. While their high popularity helps them to concentrate large amounts of liquidity, they still come with a significant disadvantage.

At this, one should always remember that storing digital assets on centralized exchanges comes with counterparty risk. With every new crash of such platforms, users flee to DEXes. 

The aforementioned FTX crash is, perhaps, the most colorful example. Users withdrew billions of dollars to DEXes and custodial wallets after the event took place in November 2022.

Thus, the usage of decentralized liquidity pools where end-users control the order books keeps growing. At the time of writing, a blockchain analytical platform DefiLlama features the following DeFi protocols with the highest TVL:

  • Lido
  • MakerDAO
  • AAVE
  • Curve
  • Uniswap

This list is not set in stone as new liquidity providers enter the market every year. Also, as new restrictions hit centralized entities worldwide, more decentralized liquidity providers are sure to emerge.

How Liquidity Provider Tokens Work

Liquidity provider tokens (aka LP tokens in short) are the tokens that a DEX generates automatically to reward liquidity providers for staking assets.

Thus, Liquidity providers can withdraw these tokens at any time and exchange them back for their collateral.

In fact, these tokens represent the share of fees that this provider earns within the pool. At this, they come with a variety of features that make them valuable:

  • LP tokens help liquidity providers to track their earnings.
  • They can be used as collateral in other lending protocols.
  • They are crucial for the smooth work of DEXes.
  • LP tokens enable liquidity providers to have full control over their staked tokens as with their help, one can withdraw assets back to a self-custodial wallet at any time.
  • One can stake LP tokens elsewhere to gain higher rewards through yield farming.
  • Some IDO (Initial DEX Offering) platforms offer bonuses for those who hold LP tokens

All-in-all, LP tokens play an important role in DeFi as a whole.

How To Make Money Providing Liquidity

In order to make money by providing liquidity, you should select a liquidity pool first. Investigate the available options and make a choice with respect to your own requirements such as asset security and profit expectations.

Note that staking stablecoins usually comes with lower returns. Pairs with volatile assets provide much higher ROI. Yet, the risks that they chrome with are much higher, too.

The majority of liquidity pools are integrated with popular wallets such as Metamask or WalletConnect. 

Regardless of the pool you choose, the integration process is quite simple. All you need to do is to connect your wallet, specify the amount of liquidity you want to contribute and grant the pool permissions that it needs to stake your funds.

After that, stake the coins, get LP tokens in return, and watch your deposit grow.

Can You Lose Money Providing Liquidity? 

Liquidity providers can surely lose money due to many different factors. Some of the key risks to consider include the following:

  • Counterparty risk. If you provide liquidity on centralized platforms, there is always a risk of these platforms being hacked or going bankrupt. 
  • Impermanent loss. While staking highly-volatile tokens comes with higher APY, liquidity providers may bear the so-called impermanent losses in case the prices of these assets experience a sharp decline.
  • Smart contract vulnerabilities. If a smart contract underlying the liquidity pool contains a bug, hackers can exploit it to steal funds from the pool. The losses are usually split across all the participants of the pool in this case.

Diversification is, perhaps, the best strategy that can help you protect yourself against such risks. Split your deposit across different pools and protocols to minimize potential losses.

Also, you can make use of smart contract insurance that some of the Defi Protocols (Yearn.Finance, for example) offer. Yet, keep in mind the associated costs as they will surely decrease your final income.

Crypto Liquidity Providing and Liquid Loans

Liquid Loans offers a few avenues related to liquidity providing.

  1. Stability Pool

Users can deposit USDL in the stability pool to act as liquidity for buying back under-collateralized vaults.

  1. LPing in PulseX

Users can take the two native tokens of the protocol, USDL and LOAN, and provide them on pairs on PulseX.

  1. PLS/USDL Pair

The Liquid Loans protocol will being incentivizing holders of the PLS/USDL LP tokens with LOAN token rewards for the first 42 days of the protocol.

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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.

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Kate is a blockchain specialist, enthusiast, and adopter, who loves writing about complex technologies and explaining them in simple words. Kate features regularly for Liquid Loans, plus Cointelegraph, Nomics, Cryptopay, ByBit and more.

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