Liquidity is a concept that’s easy to describe but surprisingly hard to visualize. At least it is when discussing financial markets, where the liquidity is entirely digital in nature and thus intangible.
We can read it in onchain dashboards revealing the depth of DEX trading pairs, and we can see it on the order books of the CEXs where bids and asks vie to be filled. But while this liquidity can be easily measured and metered, it remains in many respects, an unknown.
We can measure it but we can’t see it.
Liquidity is the dark matter of the cryptoverse, everywhere and yet nowhere. While we can observe it indirectly, on DEXs, aggregators, and trading terminals, we often have no idea where it comes from. Or to be precise, whom it comes from.
Because if there’s one thing that’s taken for granted in crypto, it’s that liquidity will always be there. Like the air we breathe, we only appreciate it when it’s absent.
So who does provide the liquidity that greases DeFi and CeFi? And why do they provide it? The lazy answer to these two questions is “liquidity providers” and “for profit.”
But we can do better than that. Way better. Because when you drill deeper into these questions a more nuanced and intriguing answer emerges.
Liquidity for hire
The first thing to know about LPs is that these liquidity providers aren’t mercenary – in fact they’re taking on substantial risk, and are often motivated by loftier goals such as ecosystem growth rather than mere profit.
For another, LPs do much more than minimize slippage – they make crypto markets more efficient in a multitude of ways.
Liquidity providers operate quietly behind the scenes, yet their contributions are fundamental in helping markets function smoothly and efficiently. On CEXs, this task is handled by specialists that are enlisted for the job, known as market makers, hired either by the token project or the exchange itself.
On DEXs, the same market makers also ply their trade, but they’re complemented by thousands of individuals who also chip in, ranging from whales with millions of dollars in assets to smaller fish with just a few hundred bucks to throw in.
Collectively, the liquidity they supply to pools on DEXs such as Uniswap and Curve allow the rest of the market to trade the tokens they want with – in most cases – tight spreads.
Having a broad idea of the sorts of firms and individuals that supply crypto liquidity is one thing – but determining exactly which entities are deploying it, where, and on what basis, however, is quite another.
Unpacking the providers behind the liquidity
It’s often impossible to tell exactly who has supplied the liquidity you’re trading: cryptocurrencies are fungible after all, so it’s not as if each token is tagged with the name of its LP.
That said, in many cases it’s possible to deduce with a high degree of probability who’s supplied the liquidity for a particular trading pair.
Professional market makers often publicize the token projects they’ve partnered with to supply liquidity on specific CEXs, and many exchanges are also not shy about revealing which LPs they work with.
And why shouldn’t they? Users want to be able to trade in a liquid environment, and thus it’s in the interests of professional LPs and market makers to be vocal about the work they’re doing.
But this isn’t always the case. Suppose organic demand for a mid-cap token is comparatively low, for instance. The token project may enlist a market maker to ensure there’s sufficient bids and asks for traders to be able to buy and sell.
This also has the effect of making the token appear more popular than it actually is. Such activity isn’t inflating the price, it should be noted – merely keeping the volume and spread at an acceptable level until organic demand picks up.
This is particularly true of newly launched tokens, where pro LPs are recruited to supply the initial liquidity.
When it comes to decentralized trading, the same principles apply as they do to CEXs in that the biggest LPs are often public knowledge.
But because blockchains enable every transaction by every user – institutional or retail – to be viewed in real-time, it’s possible to learn more. A lot more.
The rise of onchain data dashboards that convert blockchain events into human-readable stories provide deep insights into DEX liquidity – including who’s supplied it.
All eyes on LPs
Blockchains don’t generally reveal the names behind specific wallets – just the addresses – but it’s often possible to identify the businesses and individuals concerned, particularly for high-value wallets.
Some crypto companies, including certain market makers, publicize their main wallet addresses, or use identifiable wallet names (e.g. AcmeLiquidityServices.sol) so that onchain observers aren’t left guessing.
More often, though, this information can be deduced by sleuths who crowdsource wallet identification and labeling.
Major LPs on decentralized exchanges are some of the industry’s most watched whales. This mass observation isn’t watching for watching’s sake, either: it’s done to identify in an instant when significant liquidity is withdrawn from a pool.
Should an LP supplying more than 10% of the pool remove all of their liquidity, it will impact traders – both in terms of increasing slippage and in raising questions about the project itself.
A major LP like a market maker pulling their liquidity isn’t necessarily a cause for alarm – they can’t park it there forever after all – but it’s a highly suggestive onchain signal.
It could mean many things for the token, some good, some bad, and some neutral, but make no mistake, the breaking news will be traded hard.
Why supply liquidity?
On decentralized exchanges especially, there are strong incentives to become a crypto liquidity provider, not least because the process itself is so simple.
LPs deposit pairs of assets, such as ETH and USDC, into an automated market maker (AMM) such as Uniswap, forming liquidity pools that anyone can trade against. In return, they receive LP tokens representing their pool share.
When they want their liquidity back, they deposit their LP tokens and receive the same percentage of the pool back as they initially put in.
That covers the “how” part of supplying DeFi liquidity. As for the “why” component, that’s equally simple: any time traders swap one token for another directly from the pool, they’ll pay a small fee (typically 0.3%) that gets distributed back to LPs as a reward.
From an LP perspective, this all sounds great, but there’s naturally a few caveats attached. Before you rush off to become a solo liquidity provider, collecting fees on every swap, it’s worth considering the risks involved.
Firstly, money makes money: LP’ing generally isn’t particularly profitable unless you’ve got thousands – or better still tens of thousands – of dollars in liquidity on hand.
The only exception to this rule is high volume, high volatility tokens – such as new tokens that are generating serious heat – where even smaller LPs can make reasonable returns.
The second consideration when it comes to LP’ing is that there’s heightened risk when providing liquidity for volatile crypto assets.
Specifically, the risk of impermanent loss. If one of the tokens dumps in price, your profits from LP’ing could be eroded and in some cases you could even exit the pool with less capital than you started out with.
This is another reason why DeFi liquidity is largely left to the pros who know what they’re doing and have the proprietary algos to minimize risk and usually avoid losses.
Making markets work like magic
Efficient markets rely on quick, accurate price discovery and low transaction costs. Liquidity providers are invaluable in this respect here, supporting greater efficiency in multiple ways.
For one thing, their liquidity imbues crypto markets with continuous availability, ensuring that assets can be traded around the clock and there’s always a counterparty to trade with.
For another, by ensuring deeper pools and balanced order books, LPs minimize slippage: in a shallow pool, a large trade might swing prices dramatically, whereas in a deep one, the impact is negligible, leading to more predictable outcomes.
An additional – and often overlooked – benefit of liquidity providers is that they help to keep market prices balanced across the board.
Crypto LPs facilitate this by enabling arbitrageurs who exploit price differences across platforms to keep pool prices aligned with broader market rates. If a token trades cheaper on a DEX pool than on a CEX, arbitrageurs buy from the pool and sell elsewhere, restoring equilibrium.
Without sufficient LP-supplied liquidity, these corrections would be slower, leading to inefficiencies such as prolonged mispricings.
But there’s a final benefit that crypto liquidity providers bring to the industry, and this one is less easily measured – despite its impact being huge.
By deepening liquidity, LPs make crypto markets more attractive to those who’ve yet to enter – institutions and hedge funds especially.
Given the current growth in instruments like ETFs, with SOL poised to join ETH and BTC in the institutional club, there are huge incentives for making crypto liquidity deeper still.
As the industry matures, its LPs – both professional and amateur, identifiable and pseudonymous – will remain the key to unlocking its full potential. The more they bring to the party, the longer the party goes on.
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