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What is Liquidity Provision?
Imagine waiting to order inside a restaurant. Liquidity is comparable to having lots of food available. That would speed up orders and transactions, making customers happy. On the other hand, illiquidity is comparable to having limited food available and long food preparation times with a long line of customers. That would lead to slower orders and slower transactions, creating unhappy customers.
In traditional finance, banks, financial instituations, and principal trading firms all act as liquidity providers in today's markets. These entities are what is known as 'market makers' in the context of traditional financial markets. In contrast, decentralised exchanges and other decentralised finance protocols rely on liquidity pools to function.
There are no requirements for becoming a liquidity provider (LP) in DeFi other than possessing the required assets. Anyone with a MetaMask wallet can connect to the DeFi protocol like the Sumero dApp, which connects to the underlying smart contracts hosted on the Ethereum blockchain. Liquidity providers can then select a liquidity pool of a particular trading pair, such as USDC-CLAY, and deposit their assets into it in return for trading fees derived from that asset pair and/or liquidity mining rewards. Whenever other DeFi users trade USDC to Clay or vice verse on SumSwap, the protocol uses the pooled assets to fulfil these trades and gives the liquidity providers (LPs) a cut in the form of trading fees relative to their stake in the pool. This protocol is what is known as an Automated Market Maker (AMM). AMMs allow digital assets to be traded in a permissionless and automatic way by using liquidity pools rather than a traditional market of buyers and sellers.