Passive liquidity refers to the capital provided to a market through limit orders placed on an order book or deposited into an automated market maker (AMM) pool. These orders wait for a counterparty to execute a trade against them, rather than actively seeking immediate execution. The presence of passive liquidity contributes to market depth and reduces price volatility.
Provision
Market participants provide passive liquidity by placing limit orders at prices away from the current market price. In return for taking on the risk of adverse price movements, liquidity providers earn the bid-ask spread or trading fees. This strategy contrasts with active trading, where participants execute market orders immediately.
Strategy
In decentralized finance, passive liquidity provision involves depositing assets into an AMM pool and earning fees from trades. This approach exposes the provider to impermanent loss, which is the risk that the value of the deposited assets decreases relative to simply holding them. The strategy relies on the assumption that trading fees will compensate for potential losses from price divergence.
Meaning ⎊ Limit Order Book Dynamics define the fundamental mechanisms of price discovery and liquidity management within decentralized financial markets.
