Any market participant can pool money and provide liquidity for traders on the platform. This action can be compared to market makers in traditional finance in which their liquidity is used by traders on the platform to buy and sell positions of active trading pairs. In simple words, any loses and gains are debited from the liquidity pool.
In order to understand the risks and benefits of becoming a liquidity provider, we must first dive into a simulated trade flow.
The liquidity pool has 100 USDC
Alice has 10 USDC
Alice opens a 1x leverage trade with 5 USDC
Alice is at a loss of -50% on her open trade and closes this trade to prevent further loss
Alice's total loss is 2.5 USDC which is sent to the pool for a total of 102.5 USDC & Alice is sent back 2.5 USDC to her account.
the TVL of the pool has now increased to 102.5 for a 2.5% gain
Similarly, if Bob opens the same position shortly after and gains 2.5 USDC on his trade and closes his position in profit
The pool loses 2.5 USDC putting it back to 100 USDC and Bob gains 7.5 USDC (5+2.5 PnL)
All trading pairs with the selected collateral (USDC and soon USDT) route through this single pool. So all trades using USDC will trade against the USDC liquidity pool. All settled PnL is taken / given to the LP which is how liquidity providers are rewarded for their market-making. LP positions can be thought of as hedging against the collective profit traders make on the platform.
If there is a prolonged period of traders net PnL being positive month to month, then liquidity providers will have negative APR rates. However, as traders on the platform lose trades, then LP positions will profit from traders losses. Trading fees are also sent to poolers for a net amount of 50% of the trading fee. This helps LPs stay afloat during prolonged one sided and short term extremely volatile markets. Why is this model used? 1. Studies show that traders lose more often in net PnL than win. EX: Robinhood ( a popular stock trading platform ) shows that 97% of day traders lose more money than make money.
2. All pairs are traded against a single pool thus not needing to build liquidity for more exotic pairs or uncommon pairs in the market.
3. Allows for programmable and expansive liquidity pools. As any protocol can build strategies around the pool growing TVL and market activity around the protocol.
By providing LP you are going against the traders long term net PnL. As traders lose money then you accrue rewards however, if traders make money then the pool decreases in value which also decreases your claimable amount.