What is a Liquidity Provider?
As a liquidity provider (LP), you deposit tokens into a liquidity pool and these tokens can then be used by traders for swapping.Why become a Liquidity Provider?
You can earn fees or rewards whenever a trade occurs using the liquidity you deposited into the pool. The fees or rewards are typically proportional to your share of the pool. You get to earn:- Swap fees (also known as LP fees)
- Bonus incentives (e.g. yield farming rewards, protocol incentives)
you may not get the same amount of tokens back as you initially deposited into the liquidity pool. You may get less of one token and more of the other depending on price changes (on one or both of the tokens) because you are allowing traders to swap your tokens in exchange for an LP fee.
What is an AMM?
An Automated Market Maker (AMM) is a type of decentralized exchange (DEX) protocol. In traditional exchanges, a centralized orderbook matches the specific orders placed by individual buyers and sellers, and this is usually facilitated by an intermediary. Unlike traditional exchanges, AMMs use smart contracts on the Solana blockchain to enable traders to trade against the tokens deposited in a liquidity pool. The price of token assets in an AMM is determined algorithmically, based on a pricing formula. The most common formula is the “constant product” formula,x * y = k, where:
x= amount of Token A in the pooly= amount of Token B in the poolk= a constant value that never changes
k = a constant value that never changes
When someone makes a trade, the AMM adjusts the token balances in the pool such that the product x * y remains constant. In other words, the more users buy one token, the more expensive it becomes in the pool. Conversely, the more users sell one token, the cheaper it becomes in the pool.
- For liquidity providers (LPs): In an AMM, LPs deposit different token asset pairs into liquidity pools so traders can trade against those tokens. In the most common constant product-based AMM, each token in the pair being deposited is usually of equivalent $USD value (50:50). For example, LPs can deposit an equivalent value of SOL and USDC into a SOL-USDC liquidity pool.
- For traders: A trader or another smart contract can then interact directly with the AMM pool smart contract to swap one token for the other. For example, using SOL to swap for USDC in a SOL-USDC pool. This process can be done automatically on the blockchain with the exchange rate calculated based on a pre-defined mathematical formula and accounting for the available tokens in the pool. Hence the AMM can facilitate trades in a non-custodial, decentralized manner without an intermediary.
Differences between DLMM and DAMM v1/v2
DLMM
Meteora’s DLMM (Dynamic Liquidity Market Maker) pools enable LPs to earn much more fees with their capital due to precise liquidity concentration with 0-slippage bins, flexible volatility strategies, and dynamic fees. The liquidity of an asset pair is organized into discrete price bins. Tokens deposited in a liquidity bin can be swapped at the specific price for that particular bin, ensuring 0-slippage or price impact swaps for that bin. The asset pair market is established by aggregating all the different liquidity bins. LPs have the flexibility to select their volatility strategy and adjust the price range (make it narrower or wider) to concentrate liquidity based on their preferences - helping them achieve higher capital efficiency. With the higher capital efficiency, DLMM LPs can support more volume (and earn more fees) with their liquidity position, compared to adding the same liquidity on a typical DEX. In addition, DLMM allows for single-sided asset deposits, so LPs can deposit only one token in the pool to DCA (dollar cost average) to the other token in the pair. Single-sided asset deposits are also suited for token launches, where the project only deposits their base token in the pool first so users can purchase their token with USDC or SOL when the pool starts trading. In addition, LPs earn dynamic fees that are designed to capture more value from market volatility. Although DLMM LPs can potentially generate a lot more volume and fees, a DLMM pool can become “inactive” and stop earning fees whenever the active price goes out of the range set by the LP. As such, DLMM pools require more active management compared to Dynamic AMM pools. DLMM pools also don’t provide LP tokens upon adding liquidity, so once the pool is created, liquidity deposited cannot be locked permanently (unlike dynamic AMM pools). Read an overview of DLMM here. Any user can create a new DLMM pool here.DAMM v1
DAMM v1 (Dynamic AMM v1) pools are pools with a constant product AMM (automated market maker) model that are relatively more straightforward to use for LPs. Unlike DLMM, DAMM v1 pools have a fixed fee %, do not allow LPs to concentrate liquidity, and operate across the full price range so they won’t become inactive. Therefore, dynamic pools do not require active management and rebalancing from LPs. Assets in dynamic pools are also deposited directly into the vaults in the yield layer, so SOL/USDC/USDT assets will be dynamically allocated to external lending protocols to generate yield and rewards for LPs. LPs can receive yield from a few places — the AMM trading fees, the SOL/USDC/USDT lending interest, and any liquidity mining rewards collected from the platforms. Creating a new dynamic pool is permissionless, meaning any user or developer can create a new pool without approval from the Meteora team. In addition, with DAMM v1 pools, memecoin creators have the option to “burn” their liquidity by permanently locking the Meteora LP tokens (which represent the liquidity in a dynamic pool). Memecoin creators can compound and claim fees on permanently locked liquidity forever, even though they no longer have access to that liquidity. Memecoin creators can consider launching their memecoin with a Memecoin Pool, which is a subset of dynamic pools and has features specially catered to memecoin launches (e.g. a dynamic fee % schedule). Read an overview of DAMM v1 here. Any user can create a new DAMM v1 pool here.DAMM v2
DAMM v2 (Dynamic AMM v2) is also a constant-product AMM pool that requires little upkeep from LPs and is relatively more straightforward to use. However, it improves upon DAMM v1 by providing extensive configurability and features. This is to better support LPs, token launches, and launchpads, and help them win! Key features include:- SPL & Token 2022 support to enable a broad asset range
- Dynamic Fee to help maximize returns during high volatility
- Anti-Sniper mechanisms such as the Fee Scheduler (fees start higher at launch and drop over time) and Rate Limiter (fees increase depending on the trade size)
- Fee token selection (choose between Base + Quote token, or Quote token only)
- No auto-compounding of fees into the pool, for more versatile fee claims
- Transferrable liquidity position NFT to easily give ownership of your position to someone else
- Farming mechanism that is built directly into the program, not as a separate farm program
- Greater cost efficiency; creating a single DAMM v2 pool with a liquidity position costs ~0.022 SOL, compared to ~0.25 SOL for a DLMM Launch Pool
- Different options to lock liquidity; option to lock liquidity with vesting (non-permanent) or permanently, while still allowing fee claims.
- Single-sided liquidity pools using only one token for greater launch flexibility (e.g. launch your token without requiring USDC)
- Concentrated liquidity; at pool creation, developers can configure a preferred min-max price range for the pool to enable higher capital efficiency for the deposited liquidity.