In order to acquire a cryptocurrency or token on a decentralized exchange (DEX), there has to be enough of that token available on the market. The number of tokens available is the amount of liquidity the token has. The more liquidity there is, the easier and safer it is to trade.
When you make a trade however, you're not trading with a random person that happens to be making the exact opposite of your trade. Instead, you're interacting with a liquidity pool that has been filled with tokens by people known as liquidity providers. Liquidity Providers are the invisible force behind the scenes that make trading possible.
When you swap ETH for DAI, your ETH is deposited into a liquidity pool and an equal amount of DAI is withdrawn in exchange. The pool you interact with contains tokens that were provided by many different people.
Sometimes when you go to make a swap within the Rainbow app, you might see several warning messages that mention liquidity:
- Insufficient Liquidity
- Low Liquidity
- Small Market - Losing $$$
When you see a liquidity message like this, it means that there aren’t enough of the tokens you want available in a liquidity pool. In other words, no one on the market is willing to give you the token in exchange for what you are offering.
There’s not a way around this scenario except to wait and see if liquidity increases in the future. It's also very possible that a token may never have liquidity if there isn't enough market demand and no one is willing to become a liquidity provider for it.
Speaking of which...
How and why do people become liquidity providers?
Anyone can become a liquidity provider by depositing equal amounts of two tokens into a pool on a decentralized exchange like Uniswap.
If you owned 1 ETH and an equal amount of DAI, you could deposit those tokens into a pool and receive special "liquidity pool tokens" (LP tokens) or "liquidity pool NFTs" in exchange. These LP tokens or NFTs signify that you have a stake in the liquidity pool and are eligible to receive a cut of the transactions fees that the pool generates.
Anytime someone uses a liquidity pool to make a trade, they pay a small fee to the pool. That fee is then proportionally distributed to all of the liquidity providers that make up the pool. If a liquidity provider owns 10% of a liquidity pool, then they would receive 10% of the fees.
People become liquidity providers because they might have a chance to profit off the valuable service they are providing to the market. After all, they are playing a vital role in the ecosystem and need to be rewarded for doing necessary work.
It's extremely easy to become a liquidity provider and only takes a few minutes. All you have to do is go onto a decentralized exchange like Uniswap, navigate to the "Pool" section, and complete a transaction.
Becoming a liquidity provider does carry certain risks however and is not a guarantee of profitable returns. In some cases, it is even possible to lose money.
Many people tend to think that becoming a liquidity provider is always lucrative, but this simply isn't the case. Just like with any investment activity, there is a risk/reward tradeoff with liquidity providing, and it can often require a lot of time and effort to do well.
You'll have to deal with potential impermanent or unrealized loss and the volatility of the underlying assets. Furthermore, the APY/return you might see from the pool is constantly changing.
All of this being said, there is another reason why many people choose to become liquidity providers...
The Power of Yield Farming
As we mentioned earlier, liquidity providers serve a vital role in crypto markets. Without them, a decentralized exchange or protocol goes nowhere. There are many exchanges and protocols competing for liquidity, so they often have to provide additional rewards on top of just transaction fees in order to attract enough liquidity providers. Participating in these incentive programs are often referred to as yield farming or liquidity mining.
As an example, Uniswap occasionally offers its liquidity providers the ability to earn Uniswap governance tokens (UNI) in exchange for providing liquidity for certain pools. Other protocols such as Balancer, Curve, and NFT20 are also well known for rewarding providers in addition to just the transaction fees.
Before providing and locking up your liquidity to farm however, you should always research the protocol carefully to ensure it is one you trust. Not all of them are created equal, and there are some bad actors attempting to scam people.
Differences Between Liquidity Pool Providers
- Curve - Optimized for providing stablecoin liquidity
- Yearn - Automated liquidity/yield farming for a more passive-investing strategy
- Balancer - Automated portfolio manager that rebalances by following arbitrage opportunities
- Uniswap - The number 1 decentralized exchange by market volume with a high amount of liquidity
- NFT20.io - A liquidity protocol for NFTs
- The Index Coop - A provider of crypto index products that rewards providers via liquidity mining opportunities