A liquidity provider (LP) deposits assets into trading pools or order books, enabling others to trade by providing the other side of transactions. LPs earn fees from trades executed against their liquidity, the compensation for providing capital that enables market function. In Automated Market Maker (AMM) pools, LPs deposit token pairs (e.g., ETH and USDC) and receive LP tokens representing their share of the pool. When traders swap, a portion of each trade (typically 0.3%) goes to the pool, distributed proportionally to LP token holders. The risk is impermanent loss: when deposited asset prices diverge, the pool rebalances in a way that leaves LPs worse off than simply holding the assets. In traditional order book markets, market makers provide liquidity by placing limit orders on both bid and ask sides, profiting from the spread while managing inventory risk. Professional LPs use advanced strategies to optimize returns and manage risks across multiple venues. Liquidity provision is essential for functional markets, without LPs, spreads widen, slippage increases, and trading becomes impractical. DeFi protocols compete for LP capital through yield farming incentives, sometimes paying token rewards on top of trading fees to bootstrap liquidity.
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