ZoneBitcoin EditorialArticle from the Education section.
In this short article, we will give you an explanation of what are liquidity providers. We will also see why it is a central concept in the cryptosphere.
Once you understand the importance of liquidity providers, you will understand one of the essential elements of Decentralized Finance.
To put it plainly, a liquidity provider is a person who will fund a liquidity pool with tokens that they own so that trading on the platform can be carried out. In exchange for its financing, the liquidity provider will therefore earn commissions on each transaction (very often via the platform's native token).
If there is such enthusiasm for becoming a liquidity provider, it is of course for the gains that can be made, in passive mode. This is why there are many people who are interested in becoming a liquidity provider.
Liquidity pools are used and operated by decentralized exchange platforms (DEX) (this is the opposite for example to centralized platforms like Binance, for example).
An example of a decentralized platform would be UniswapEg.
Decentralized platforms use smart contracts based on market makers to enable exchanges between different cryptos.
This is the main difference with centralized platforms which will use a classic order book according to the purchase or sale price of the users who buy or sell.
Basically, while on a centralized platform, traders directly exchange their assets with each other, on a decentralized platform, you go through a third party to make your exchange. This part is called the liquidity pool.
Thus, as long as the liquidity pools have sufficient liquidity, operations can be carried out. Conversely, if the liquidity pools are not large enough, trades cannot take place.
Hence the importance of having liquidity pools with sufficient funds!
So this is why liquidity providers are so important! Crucial even because they are the ones who will finance these liquidity pools.
To encourage them to do so, the platforms pay them rewards which are part of the transaction fees.
Liquidity providers typically fund two different assets to allow users to trade these two assets. Indeed, trading works in pairs, as you know. You deposit one crypto to get another. This is the very principle of trading.
To give you a concrete picture, a liquidity provider can choose for example to finance a liquidity pool of the equivalent of $2000 in Ether and $2000 in DAI for example. The liquidity provider therefore allows traders to be able to carry out transactions with these two assets. And, therefore, each time a transaction is made, the liquidity provider will pocket a reward.
That's the job of a liquidity provider.
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