Limited Partner (Venture Capital) vs. Liquidity Provider (Crypto) — The Different Definitions of LPs
Last week, I was talking with a couple of friends from the crypto and startup arena when the topic of Venture Capital fundraising came up. And when we, as VCs, talk about fundraising, there are a couple of conjunction words that come hand-in-hand. To list a few these are standardized terms like a mandate, fee structure, carry percentage, fund status, and anchor LP.
If you ask a VC what LP stands for, in a split second, they will answer ‘Limited Partner’. But what if you ask that same question to someone in the crypto space? High chances they will blurt out ‘Liquidity Provider’. And this is exactly what happened to us last week. If you understand not only the direct definitions of these two separate acronyms but also the importance of each party in their respective markets, you will be intrigued by how contrasting these two types of LPs could be.
Part I: Limited Partnerships in Venture Funds?
The business entity of a VC fund is in the form of a Limited Partnership (L.P.), where essentially two or more partners go into business together. Limited Partnerships consist of Limited Partners (“LPs”), those who are only liable up to the amount of their investment, and the General Partner (“GP”), which has unlimited liability. Essentially, the LPs are the capital providers while the GPs are the day-to-day managers of the fund.
As stated in this Angelist article, LPs are critical to the success of venture funds because they provide the majority of the capital needed to run a fund.
Who Can Be an LP For a Venture Fund?
Depending on how the fund is structured, you must be an accredited investor or a qualified purchaser to become an LP of a VC fund. This in short words means that willingness is not enough. You can refer to the article below for further information but essentially being an ‘accredited’ investor assumes you are sophisticated enough to make risky financial decisions. As stated in this Crunchbase article, sophistication, in this case, is a euphemism for wealth.
How Do LPs Earn Returns?
Venture capital investing is notoriously risky thus when LPs commit to providing capital in venture funds they may not see any returns at all. In fact, they may not even be able to redeem their principal investment.
On the rosy side of the story, if the GP does a good job in investing in the right startups, the venture fund might produce returns and these returns will be distributed to LPs. However, because the venture game is a long marathon than a quick 100m sprint, it may take up to 7+ years for portfolio companies of a venture fund to go through a ‘liquidity event’ (IPO, acquisition, etc.). This means that the time it takes for a fund to share returns, also known as distribution, to LPs takes a relatively long time.
Why Would LPs Invest in Venture Funds Rather Than Other Financial Opportunities?
A family office, for example, may choose to become an LP of a particular venture fund instead of investing in bonds, stocks, mortgages, and other short-term investments because of two reasons:
- Access to information: LPs may get updates of companies the GP invests in and such information asymmetry may give you new investment opportunities (ie. possible direct investment through a SPV)
- Access to the right network: LPs may want to develop relationships with other investors involved in the venture fund and this could provide valuable access to future investment opportunities
Part II: The Role of Liquidity Providers in Automated Market Makers (AMMs)
In order to explain what is the role of a liquidity provider in an automated market maker and the entire DeFi crypto space, it is important to first understand the term ‘market maker’.
Market Maker?
There are multiple players that take part in the market. These include buyers, sellers, dealers, brokers, and market makers. As stated in Investopedia,
Some help to facilitate sales between two parties, while others help create liquidity or the availability to buy and sell in the market. A broker makes money by bringing together assets to buyers and sellers. On the other hand, a market maker helps create a market for investors to buy or sell securities.
Market makers, in traditional finance, are your typical large banks or financial institutions such as Morgan Stanley, Deutsche Bank, and UBS. Their role is to keep the financial market functioning, meaning if you want to sell a Tesla convertible bond, they are there to buy it. Similarly, if you want to buy an Apple stock, they are there to sell it to you. And the way they make money is by charging a spread on the buy and sell price.
We also have market makers in the crypto space: the centralized exchanges (“CEX”). These are your Coinbase, Binance, FTX, and Upbits of the world. What is interesting is that in order to achieve a fluid trading system, crypto CEXs, like their counterparts in traditional finance, rely on professional traders or financial institutions to provide liquidity for trading pairs. These individuals and/or entities offer multiple bid-ask orders to match those of retail traders. Due to their roles in providing liquidity for trading pairs, in this system, professional traders and financial institutions are the liquidity providers of market makers.
Similar to public stock market makers, CEX market makers facilitate the process required to provide liquidity for trading pairs.
Then, What’s an Automated Market Maker?
Unlike centralized exchanges, decentralized exchanges (“DEX”) were born from the idea of eradicating all intermediary processes involved in crypto trading. One of the main differences between these two forms of exchanges is that autonomous protocols called AMMs replace order matching systems and order books. This is possible because AMMs leverage the power of smart contracts, which are self-executing computer codes. This means users who participate in DEXs are not trading with another trader but instead are trading against the liquidity locked inside smart contracts. Hence, why DEX allows peer-to-contract, meaning there isn’t a seller or buyer on the other side of the transaction.
Refer to the following article for a full list of differences between CEX and DEX:
Any entity or individual can become a liquidity provider as long as she, he, or it meets the requirements hardcoded into the smart contract (remember: smart contracts that are written on the blockchain can’t be modified).
The first-ever decentralized platform to successfully utilize an AMM system was Uniswap, which is a DEX built on the Ethereum blockchain. Since the inception of Uniswap in 2018, a plethora of DeFi exchange protocols have emerged ever since including Pancake Swap, Curve, Balancer, Sushi Swap, and Osmosis.
Role of Liquidity Providers in AMMs
Just like any market, AMMs require fluid liquidity to function properly. Liquidity pools — which can be thought of as a pot of cryptocurrency assets locked within a smart contract used for decentralized trading, lending, and borrowing — need to be adequately and timely funded in order to avoid slippages. One way to do so is by encouraging liquidity providers to deposit digital assets (this may ETH, tokens like ATOM, or stable coins like USDT) in a designated liquidity pool so that other users can trade against these funds.
Rewards for LPs
As an incentive, DeFi exchange protocols reward LPs with a fraction of the fees paid on transactions executed on the pool in the form of a token. If the total value of the liquidity you have provided represents 1% of the total pool, you get to receive an LP token which represents a 1% value of the accrued transaction fees. With these LP tokens, you can also capitalize on yield farming opportunities by depositing — or ‘staking’ — this LP token into a separate lending protocol and earn extra interest.
Besides the LP tokens, AMMs also issue what is called ‘governance tokens’ to LPs and traders participating in the liquidity pool. As the name implies, if you hold a governance token you get to vote on issues relating to the governance of that AMM protocol.
Risks LPs Need to Take Into Account
When you provide liquidity to an AMM, you are exposed to what is called impermanent loss. This can occur when the price ratio of the two pooled assets fluctuates. An LP will incur losses when the price ratio of the pooled assets in a specific liquidity pool deviates from the initial price at which he/she deposited. However, this loss is denominated ‘impermanent’ because there is a probability that the price ratio will revert back. This loss becomes permanent if the LP decides to withdraw before the price ratio reverts back. However, note that the earnings from transaction fees and yield farming can sometimes cover such losses.
TL;DR
To wrap up this lengthy post here is a tabulated summary comparing the two varying forms of LPs:
I am still learning and building my knowledge and network in Web3, and I would welcome the opportunity to connect with more people in the space. If you are building in Web3 or have feedback on this piece, please reach out by Twitter (@minchi_p) or LinkedIn 🙋🏻♀️
If you enjoyed my writing and want to encourage me to do more, you can buy me a coffee! A warm cup of ☕️ powers my day and will also power my next piece.
