To become a liquidity provider, users in a DeFi protocol
only have to interact with the protocol's smart contracts. But it begs the question: why would anybody want to become a liquidity provider?
This is where incentives come into play.
AMM DEXs need as much liquidity as they can get. Traders will always seek exchanges with the highest liquidity to get the most efficient token swaps. Liquidity attracts activity, and in the ultra-competitive world of DEXs, incentives and rewards are used to attract people to provide liquidity to their pools.
These rewards are offered during the liquidity mining process. As mentioned at the beginning of this article, there are main rewards mechanisms: trading fee distribution and native token rewards.
DEXs typically charge a 0.3% trading fee on every trade. These fees are then distributed among all liquidity providers within a given pool.
Native token distribution instead rewards providers directly with a DEX’s native token. Let's take for example an AMM DEX called XYZ. The XYZ protocol has its own native token called the XYZ token.
Since it's still new, it needs to be able to attract liquidity providers by giving extra incentives. It won't be able to attract the liquidity providers' attention just by giving out a 0.3% trading fee reward since they are still new and have very low trade activity.
So how can they attract liquidity and platform activity? With their XYZ token. Since XYZ token is already trading on crypto exchanges, and it has value, liquidity providers will be attracted to provide liquidity to XYZ protocol with XYZ token rewards..
In the earlier example of John, the liquidity provider => if John provides 10 ETH and 16,000 USDC to the ETH-USDC liquidity pool at XYZ protocol, John will get this extra reward in the form of XYZ tokens. But how many tokens will he receive? This depends on the DeFi protocol's token reward policy and how many liquidity providers are contributing to the same pool.
If there is a total of 100 ETH and 160,000 USDC in the same ETH-USDC liquidity pool, John will be able to get 10% of the XYZ token reward for whatever the XYZ protocol team decides to give out that day for the ETH-USDC pool.
Each protocol's native token has its own use case, so you'll need to check the project guidelines for specifics. In most cases, they are used as governance tokens.