Providing Liquidity is similar to funding a Bank’s treasury. You enable Decentralized Exchange transactions, and get paid a portion of the fees in return
Liquidity and liquidity pools (LP) are a big part of crypto and decentralized finance (DeFi).
Let’s say you get a gift of 100 NEWCOINS, and I tell you they’re worth a million dollars each. Does this mean you’re instantly a millionaire? Well, maybe. First you have to find someone willing to buy a NEWCOIN for a million bucks.
If no one’s willing to do that (or even buy it for $10), then NEWCOIN has a liquidity problem.
“Liquidity” refers to how easily an asset can be traded. Fiat cash, like the US Dollar, is very liquid: people trade it for things all the time! If you own a home, that home is not so liquid: it’s hard to trade a home for something, even if the home is worth a lot.
<aside> 💧 Liquidity is a big deal—for you and a token’s project! Better liquidity typically means:
When you “provide liquidity” you agree to participate in automatic trades between two kinds of crypto assets. There is usually an incentive for doing this: you’ll earn passive income from trading fees.
Providing liquidity involves putting two crypto assets (the pair) into a liquidity pool (LP). It’s called a pool because in theory, there are lots of people contributing to it. There’s a pair of tokens because pools allow people to swap one for the other.
Say a pool has 10,000 Token-A and 1,000 Token-B in it. If you have 1 Token-B, you could do a swap with the pool and get 10 Token-A out of it, minus a small percent for a swap fee.
Now the pool has 9,990 Token-A and 1,001 Token-B.
If you want to provide liquidity for this pool, you would need to add both tokens to it. Some pools might give you a special LP token for doing this (kind of like a receipt). Other pools may simply accept your tokens and give you nothing immediately.
As people swap and pay their fees, the pool will split up the fees among the providers, including you.
There are many different LPs out there. Generally, the process to provide liquidity is similar.