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Ask your favorite AI what liquidity providers do for crypto markets and the first sentence they’ll spit out will invariably contain the word “lifeblood.” It’s a good phrase, but like all phrases that have been commandeered by AI, it’s become a cliched one. So let’s try a different analogy. And not just a different analogy, but a better one, which will achieve two things: it’ll make it easier to visualize the role played by crypto liquidity providers and it’ll prove that this article wasn’t written by AI.
So here goes: liquidity providers (LPs) are like gravity. They’re the invisible force that allows crypto markets to move and yet something we take for granted. Take them away, however, and we’d immediately notice their absence. But there’s another way in which LPs are like gravity: their force varies between ecosystems.
In regions where this force is stronger, such as on leading CEXs, spreads are tighter and thus pricing scarcely diverges when a large order is executed. But in low gravity regions – say a newly launched token on an unpopular L2 – even the smallest of buys can cause wild volatility. It’s the difference between walking on the earth and jumping on the moon. The latter might be fun for five minutes, but when you’ve got to live in a world 24/7, something approaching Earth’s gravity of 9.8 m/s2 is perfect.
That’s the goldilocks zone that all crypto exchanges are aiming for: a place where slippage is low and the bid-ask spread is tight but without wasting liquidity by allocating too much of it to any trading pair. There might be hundreds of billions of dollars of crypto liquidity swilling around the industry, but it’s nevertheless a finite resource and thus needs to be intelligently deployed. On reflection, perhaps the lifeblood analogy was better.
Who’s on the Other Side of Your Trade?
A simple rule of all markets is that for every buyer, there must be a seller and vice-versa. Yet most crypto users scarcely consider who’s on the other side of the trade. When you swap USDC for ETH using an AMM, the process is automated (hence the name Automated Market Maker). But just because it’s a smart contract executing the trade doesn’t mean there isn’t an individual or organization on the other side. Indeed, there has to be because the smart contract isn’t simply minting ETH on your behalf.
So who’s in the liquidity pool accepting your USDC and giving you their ETH? Or if you’re trading on an order book-based exchange, who’s creating the Ask, allowing you to buy ETH at a predetermined price point? Based on volume, the answer is overwhelmingly professional liquidity providers: companies and high net-worth individuals (HNWIs) who earn a fee for every swap with which they’re involved.
There’s a caveat to that answer, though, which is that based on the total number of LPs, ordinary users vastly exceed pros. An ETH-USDC liquidity pool may have assets that have been placed there by 100 different entities, all looking to provide a service and earn a fee for their efforts. $100 of liquidity here; $2K there. Modest amounts of liquidity provided by regular users can add up to a lot when it’s pooled together.
But in the vast majority of cases this is still just a drop in the ocean compared to the amounts that professional LPs provide. Without them, crypto would exist in a permanent state of low gravity, with prices bouncing around all over the place. And when it comes to professional LPs, there’s a specific group that does most of the heavy lifting here (which, for the record, is another tenuous gravity analogy) – market makers.
How Market Makers Make Markets Work
Across centralized and decentralized markets, the line between market maker and liquidity provider is often blurred. Empirically, CEXs have been the preserve of market makers, enlisted by either the exchange itself or the project seeking to prop up liquidity for its token. That model hasn’t changed a whole lot in the last few years: there are more tokens and more market makers than ever, but they’re still reducing the gap between bid and ask prices, allowing transactions to occur without significant price volatility.
On DEXs, however, the role of market makers has evolved. For one thing, they’ve become ubiquitous, whereas once they were scarce, enlisted only to support the most popular tokens or well-funded projects. Now, they’re everywhere, supporting everything from multi-billion dollar cap stablecoins to micro-cap memecoins.
At the same time, the decentralized trading landscape itself has been evolving, and as a result market makers are no longer limited to placing assets in an AMM pool and letting smart contacts handle the rest: now they’ve got their own proprietary algos to wield and an array of different ways in which to deploy their liquidity. As a result, DeFi market makers are playing a larger role than ever by optimizing LP strategies, deploying bots for active management, and creating bespoke strategies across multiple AMMs and chains.
Hybrid approaches are also emerging. Protocols like dYdX and GMX blend order books and liquidity pools, requiring new types of LPs who understand both traditional and DeFi-native mechanics. Meanwhile, some DeFi protocols are experimenting with RFQ (request-for-quote) systems, allowing professional market makers to plug into decentralized venues while preserving tight spreads and efficient execution.
Many Roles, One Goal
As we’ve established, liquidity providers assume many forms, ranging from ordinary users, throwing a few hundred bucks into a liquidity pool and earning a couple of bucks in return as swap fees, to professional market makers with hundreds of millions of dollars at their disposal. The beauty of crypto is that despite this seemingly piecemeal approach, it all works. Every time you swap a token onchain or on a CEX, it doesn’t matter who the counterparty is – all that matters is that they’re there to accept your trade, or for you to accept theirs.
While market makers, as well as ordinary LPs, aren’t going away, the future of liquidity provision is likely to be hybrid and increasingly automated. Market makers will continue to dominate on CEXs but will expand their presence in DeFi as decentralized exchanges evolve to incorporate more CEX-like features such as order books.
Onchain liquidity is also likely to become more modular, offering programmable incentives, dynamic fee structures, and even AI-driven rebalancing. Expect to see more protocols exploring intent-based trading, where liquidity routing is abstracted away, allowing users to specify desired outcomes such as “best execution” while backends source optimal liquidity from multiple providers.
Two things can be said for certain: crypto is a better place for everyone when liquidity is deeper. And AI, for all its flaws, is probably right about liquidity – it’s the lifeblood of crypto.
Image by Grace Baker from Pixabay
