Liquidity providers (LP) are generally the counter-party of traders, so LPs will take market-making profits and risks.
For example, if all positions from traders in the market combined are on the side of longing ETH, the AMM will be the counter-party and take short positions. In this case, if the ETH price drops, LPs will make profits; if the ETH price increases, LPs will suffer losses.
Net Asset Value (NAV), the ratio between the collateral token and LP token, will reflect profits and losses.
When you stake collateral tokens (using USDC as the example) in the related pool, you will receive LP tokens as the staking proof (similar to how Uniswap works).
The NAV can start as 1 USDC / LP Token (1:1), meaning if you stake 50 USDC at this moment, you will receive 50 LP tokens.
After market activities take place, the NAV will change accordingly. So, for example, if you staked your USDC when the NAV was at 1:1, and now it has raised to 1.02:1, you can then redeem 51 USDC with your 50 LP tokens at this moment.
In an opposite condition, let’s say you staked your USDC when the NAV was 1.02:1 and try to un-stake when it drops to 1:1, you can then redeem ~ 49 USDC with your 50 LP tokens.
One of the common factor that can lead to NAV reduction is a drawback, as shown in the graph below
Other than marketing making, LPs also have other revenue sources for making profits and balancing out risks.
Please refer to the LP revenue & risk sources.
LP Revenue Sources:
- A portion of the transaction fees
- Market-making profit from the spread
- Liquidation penalty
- Extra mining rewards if the liquidity mining program is live
LP Potential Risks:
- Positions holding related risks
- AMM bankrupt losses