In the cryptocurrency and DeFi (Decentralized Finance) industry, the term Liquidity Providers (LPs) refers to Decentralized Exchange (DEX) users who fund a liquidity pool with crypto assets they own.^[1] [3]

The crypto assets are used to facilitate trading on Automated Market Makers (AMMs) such as Uniswap, SushiSwap, and MindSwap. Liquidity Providers often provide two or more types of tokens and earn passive income on their deposits.^[2]  [4]

Trivia

• In exchange for providing funds, users earn trading fees from the trades that happen in their liquidity pool, proportional to their share of the total liquidity.
• Users who provide liquidity must keep in mind smart contract risks and impermanent loss.^[5]
• As anyone can be a liquidity provider, AMMs have made market making market making more accessible. ^[6]

Introduction

When users fund liquidity pools, they are usually required to fund two different assets to enable traders to switch between one to the other by trading them in pairs. ^[7]

Liquidity Pools in DeFi

Liquidity pools are leveraged by decentralized exchanges that use automated market maker-based systems to allow trading of illiquid trading pairs with limited slippage. Instead of using traditional order book-based trading systems, such exchanges use funds that are held for every asset in every trading pair to allow trades to be executed. ^[8]

While trading illiquid trading pairs on order book-based exchanges could lead to suffering from great slippage and the inability to execute trades, the advantage of liquidity providers is that trades can always be executed as long as the liquidity pools are big enough. ^[9]

Other popular exchanges that make user of liquidity pools on Ethereum are Curve Finance and Balancer. Liquidity pools in these protocols contain ERC-20 tokens. Similar equivalents on Binance Smart Chain (BSC) are PancakeSwap, BakerySwap (BAKE), and BurgerSwap, where the pools contain BEP-20 tokens. ^[11]

Pooling liquidity is can be used in a number of different ways such as Yield Farming or Liquidity Mining. Liquidity pools are the basis of automated yield-generating platforms like yEarn, where users add their funds to pools that are then used to generate yield. ^[12]

When a user provides liquidity to Uniswap or lending funds to Compound, they are rewarded tokens that represent their share in the pool. Users may also deposit those tokens into another pool and earn a return. These chains can become quite complicated, as protocols integrate other protocols’ pool tokens into their products, and so on. ^[13]

Liquidity Provider Example

A liquidity provider may provide a liquidity pool with $5,000 worth of (ETH) and $5,000 of DAI to allow trading back and forth between the two. Every time a trade on the ETH/DAI liquidity pool is executed, the liquidity provider in question would receive compensation for having funded the pool in question.^[10]

Liquidity Provide (LP) tokens

When liquidity providers provide liquidity successfully to any of the liquidity pools on the DEX, they get liquidity provider tokens, or LP tokens, as a receipt, which allows them to claim their original stake and interest earned. These LP tokens signify ownership of their associated liquidity in the pool. The LP tokens track individual contributions to the liquidity pool and are proportionate to the share of liquidity in the overall pool. These LP tokens can be used further for yield farming, collateral for loans and many other purposes.
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