Liquidity Providing in Web3

May 10, 2022

What is Liquidity and Why Should I Care?

Liquidity refers to how easy it is to convert one cryptocurrency coin into another. If there are lots of buyers and sellers for a particular coin it is liquid - it'll be easy to trade. If there are few buyers or sellers it will be illiquid or difficult to trade.

Crypto exchanges want to make sure that there is plenty of liquidity for all coins on their platforms so that people will choose to trade with them. For that reason they provide incentives for people to provide liquidity for popular coin pairs.

What Does it Mean to Provide Liquidity?

Providing liquidity entails locking up an equal value of two coins on a crypto exchange. Then, when a trade is made, rather than matching a buyer and seller at exactly the right moment the exchange uses the "liquidity pool" of coins (provided by people who have coins locked up) to complete the trade.

The mechanism for how the exchange then puts the coin pool back into balance is a more complex topic discussed here.

How Do I Make Money From Providing Liquidity?

In exchange for locking up coin pairs the exchange pays the liquidity providers (you, if you've locked up any of your coins) in two ways:

1. A share of trading fees the exchange charges people who are making trades

2. Extra coins (sometimes the exchange's own coin) as an incentive to make sure that their exchange has the most liquidity.

What questions do you have?

Did we miss anything in the explanation? Please reach out and let us know!