Short for Liquidity Providers, LPs provide their tokens as liquidity on DeFi exchanges apps in exchange for receiving a percentage of the fees generated by the system
In order to understand the role of an LP, we must first highlight the difference between ordinary exchanges and decentralized exchanges that utilize LPs. On an ordinary exchange, buyers and sellers come together to trade with one another. The exchange uses an orderbook to record the prices at which buyers want to buy and sellers want to sell a token. That orderbook can then match buyers and sellers at similar prices to carry out the trade.
LP-based decentralized exchanges (DEX) don’t have an orderbook of buyers and sellers. Rather, they rely on a unique system known as an automated market maker, which is basically a smart contract that holds two assets in reserves. These exchanges then allow buyers and sellers to conduct deals using funds stored for each asset in each trading pair. Essentially, the AMM functions as the counterparty of each trade.
The percentage of the liquidity pool that liquidity providers give determines how much they are paid. They are normally required to finance two separate assets when funding the pool for traders to swap from one to the other by trading them in pairs. For example, a liquidity provider may offer 5,000 dollars worth of Ether and 5,000 dollars worth of USD-pegged decentralized stablecoin DAI to a liquidity pool, allowing trade between the two. As a result, every time trade on the ETH/DAI is made, the liquidity provider in question receives compensation for funding the pool.