Are Crypto Liquidity Providers Involved in Trading?

Crypto liquidity providers (LPs) provide liquidity. That much is obvious. They do so on behalf of centralized and decentralized exchanges as well as for specific token projects. That much is also obvious. But is their role a passive one in which they simply supply the liquidity for the rest of the market to use, or do they assume a more dynamic role by actually executing trades in order to match bids and asks?

When it comes to this latter matter, there’s a good deal of confusion about what LPs actually do. So let’s examine the evidence and see if we can arrive at a clearer understanding of what crypto liquidity providers do and, crucially, what they don’t. As you’ll discover, while there are parallels between LPs and market makers, there are also key differences. Let’s consider the task taken on by each entity in turn.

Deep Liquidity on Demand

Liquidity providers – be they dedicated LPs or market makers – inject capital into the crypto ecosystem, ensuring you can buy or sell your favorite tokens without moving the market. But not all liquidity roles are created equal, because while liquidity provisioning and market making both benefit end-users, they do so in different ways, resulting in discernibly different outcomes.

Liquidity providers, like market makers, take their business seriously – because it is business after all, in which the aim is to generate revenue from providing a useful service. That service, in the case of LPs, means supplying their precious liquidity to order book exchanges or adding it to DEX pools. Once that liquidity is supplied, and the desired price levels set, their work ends there. All that’s left to do is monitor, adjust parameters if necessary, and collect liquidity – together with any fees earned – when the time comes.

It’s clear that a crypto liquidity provider, therefore, is entirely neutral, with neither the motivation nor the means to move the price of crypto assets by matching bids and asks. It’s simply not part of their remit and does not align with their risk parameters. That’s not to say that liquidity provision is entirely risk-free – there’s still the potential for LPs to lose money through variables that include impermanent loss in the case of DEX pools. Provided they set their liquidity at the correct price points, however, and monitor it closely, they should generally be immune from this hazard.

You might be wondering, since LPs aren’t actively involved in trading by matching bids and asks, what value they bring to traders. The answer is depth. By adding deep liquidity, they enable traders to swap tokens without incurring high slippage, even when executing large orders. This is as valuable on centralized exchanges as it is on decentralized exchanges that use an AMM or order book model.

In this respect, liquidity providers supply a similar base service to market makers, which are also in the liquidity provision business. But the role of market makers goes further from passive LP’ing to active order fulfillment.

What Market Makers Do Differently

The process we have described up until now broadly describes market makers as much as it does liquidity providers. But the former don’t simply deposit liquidity with the goal of adding depth: they also make markets by using algorithms to layer limit orders across price levels, closing CEX spreads between bids and asks.

In DeFi, they perform a similar task with order books on protocols like dYdX or Serum, where smart contracts handle the matching, and on AMMs such as Uniswap by supplying liquidity at tighter price points than a simple liquidity provider generally sets. The benefit of this process is that it tightens spreads, stabilizes prices during volatility, and ensures that traders experience reliable order execution. 

To help visualize the differences between LPs and market makers, let’s perform a simple side-by-side comparison:

So, Are Liquidity Providers Involved in Trading?

To answer our original question, then, are liquidity providers involved in trading? No. These providers aren’t out there actively trading like market makers, who actively participate in buying and selling to support markets. Instead, provisioning is about parking capital passively: think of it as lending your assets to the market for others to trade against, earning fees without the constant hustle.

That said, the lines can blur, especially with pros who mix both worlds. But at its core, liquidity provisioning keeps participants out of the trading trenches, focusing on stability over speculation.

If you’ve labored under the misconception that liquidity providers and market makers are the same thing, don’t worry: it’s an easy mistake to make. Particularly given that many businesses do both, alternating between passive LP’ing and active market making according to the requirements of the exchange or token project that’s enlisted their services.

For a popular market such as BTC/USD, for example, there’s likely no need for market making since there should be sufficient organic demand from traders swapping between the two assets. For a newly launched token on a DEX, however, or a mid-cap token that’s at an early stage in its life-cycle, a market maker may be needed to ensure that traders can execute swaps at the desired price.

What liquidity providers don’t do is step in and start propping up the market if volume is low and a token looks like it could use some support: that’s not their mandate, and thus they limit their role to adjusting the price point at which they set their liquidity for AMMs.

So the next time you hear that Company A has been enlisted to provide liquidity for Token A or Exchange C, know that they’re doing just that and only that. The price discovery – the actual price that the tokens are exchanged for – falls to the market to decide. LPs are only there to make sure the liquidity is deep and distributed.