Liquidity Providers in the Crypto Market: Function, Risks, and AML Considerations

The rise of cryptocurrency markets has brought with it a host of new actors and mechanisms that underpin trading activity. Among these, the role of Liquidity Providers (LPs) is fundamental. Without LPs, trading platforms would be unable to function smoothly, users would encounter wide spreads between buy and sell prices, and the overall market would become inefficient and unattractive. Yet while LPs are indispensable to the health of modern crypto markets, they also introduce significant and nuanced anti‑money laundering (AML) and counter‑terrorist financing (CFT) risks. Understanding who they are, how they operate, and how regulators and exchanges should engage with them is therefore critical for maintaining trust and integrity in the sector.

Liquidity Providers Explained

Liquidity provision in crypto markets mirrors, to some degree, the concept of market‑making in traditional finance. LPs place assets into circulation to ensure that buyers and sellers can transact quickly and at prices that reflect fair market conditions. By narrowing the gap between bid and ask prices, they solve the problem of “thin” order books, where trades would otherwise be slow, costly, and prone to manipulation.

On centralized exchanges (CEXs), liquidity provision typically takes the form of professional market‑making. A trading firm may enter into a formal agreement with a licensed exchange to maintain an orderly market by continuously placing buy and sell orders around the prevailing price of an asset. For instance, an LP might deposit large amounts of Bitcoin and stablecoins, then deploy algorithms that place bids slightly below market and asks slightly above. Retail traders are matched against these orders, and the LP profits from the spread and, in some cases, rebates or incentives provided by the exchange.

On decentralized exchanges (DEXs), the mechanics are very different but the function is similar. Here, liquidity is provided not through an order book but via automated market makers (AMMs). An entity deposits equivalent values of two tokens into a “liquidity pool” governed by a smart contract — for example, ETH and USDT. In return, the provider receives LP tokens, which represent its share of the pool. Traders who swap tokens interact directly with the pool, and fees collected on each trade are distributed back to LPs. This model is permissionless: anyone with the required assets can become an LP, from retail users to sophisticated funds.

Who Are the Liquidity Providers?

While in decentralized finance retail participants may contribute, the majority of meaningful liquidity provision in the crypto sector is carried out by sophisticated, well‑capitalized entities. Specialist market‑making firms such as Wintermute, Jump Crypto, and GSR operate across dozens of exchanges, deploying quantitative strategies to provide liquidity at scale. Hedge funds with a crypto focus also participate, often as part of market‑neutral strategies. In some cases, exchanges themselves operate proprietary trading desks to guarantee baseline liquidity on their platforms, although this raises potential conflicts of interest. Over‑the‑counter trading desks, which facilitate large private transactions, also act as liquidity providers in order to manage their inventory and hedge exposures.

The common thread is that LPs are not casual participants. They are entities with significant technical capability, large capital reserves, and a central role in the functioning of crypto markets. Precisely because of this importance, their activities warrant careful regulatory and compliance attention.

The Regulatory Landscape

The regulatory treatment of LPs remains an evolving and often grey area. In most jurisdictions, an LP that is merely trading for its own account is not required to hold a licence. Such activity is considered proprietary trading, positioning the LP as a client of an exchange rather than a service provider to the public. As a result, many LPs operate without direct licensing.

However, international standards — in particular, the Financial Action Task Force (FATF) definition of a Virtual Asset Service Provider (VASP) — complicate the picture. Depending on interpretation, the activities of an LP could be viewed as falling within the scope of “participating in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset.” Regulators are still refining their positions on this point.

In Hong Kong, the Securities and Futures Commission (SFC) has made it clear that licensed virtual asset exchanges bear the regulatory burden. The exchange must be licensed, but the liquidity provider, as a trading client, is not required to obtain a separate licence solely for its liquidity provision activities. That said, if the LP engages in other regulated businesses, such as asset management or securities dealing, it must obtain the relevant authorizations.

The crucial point is that, even if LPs are not directly licensed, they are indirectly regulated through the exchanges on which they operate. Licensed exchanges in Hong Kong and other jurisdictions carry full obligations under AML/CFT legislation, including the AMLO, to conduct customer due diligence on institutional clients. This makes the exchange the first line of defence in managing the risks associated with LPs.

AML and CFT Risks Associated with LPs

The scale and complexity of liquidity provision mean that LPs can pose significant AML/CFT risks. The most obvious is that an LP could serve as a vehicle for illicit actors to channel large volumes of funds through exchanges under the guise of market‑making. Because LPs transact at high frequency and with substantial capital, their flows can be used to layer and integrate criminal proceeds in ways that are difficult to detect.

There are also risks of manipulative practices. Wash trading — where an LP trades with itself to inflate volume — or layering strategies designed to create misleading market signals can not only undermine market integrity but also obscure the underlying source and purpose of funds. The involvement of LPs in decentralized finance adds further challenges, as the permissionless nature of DEXs allows actors to engage without traditional onboarding, making the provenance of funds even harder to establish.

Managing the Risks: A Risk‑Based Approach for Exchanges

Given these challenges, exchanges must adopt a rigorous and risk‑based approach to managing LP relationships. Treating LPs as though they were ordinary retail customers is inadequate. Instead, exchanges should apply institutional‑grade due diligence at the onboarding stage, beginning with a full Know Your Business (KYB) process. This requires unwrapping all corporate layers until the true ultimate beneficial owners are identified, verifying the identities of directors and key controllers, and demanding clear evidence of source of wealth and source of funds. Reliance on simple self‑declarations is insufficient when multi‑million‑dollar liquidity positions are at stake.

Once onboarded, LPs must be subject to ongoing monitoring tailored to their unique trading patterns. Blockchain analytics tools can be deployed to trace the origin and destination of funds, flagging any links to mixers, sanctioned entities, or darknet markets. Exchanges should maintain continuous oversight of an LP’s trading behaviour, watching for inconsistencies between declared strategies and observed activity, as well as red flags such as one‑sided betting or unusual directional exposures. Where red flags arise, enhanced due diligence must be triggered without hesitation.

Contractual arrangements can also reinforce compliance expectations. Agreements between exchanges and LPs should contain explicit AML obligations, including warranties of compliance, rights to demand further information, and the ability to suspend or terminate relationships where suspicious activity is detected.

Conclusion

Liquidity providers are indispensable to the functioning of the crypto market. They ensure that buyers and sellers can transact efficiently, giving exchanges the depth and stability necessary for trading to thrive. Yet their very importance, combined with the scale of their operations, makes them attractive channels for illicit finance if not properly managed.

The regulatory environment remains in flux, and LPs themselves often operate without direct licences. This reality places the burden squarely on exchanges, which must adopt rigorous due diligence and monitoring frameworks to mitigate the risks. For jurisdictions like Hong Kong, where virtual asset regulation is becoming increasingly sophisticated, the expectation is clear: exchanges must not only understand who their liquidity providers are, but also demonstrate that they have taken meaningful steps to assess and control the risks involved.

As crypto markets mature and liquidity provision grows in scale — increasingly overlapping with cross‑border fund flows, hedge fund strategies, and even connections to decentralized finance and crypto‑exchange ecosystems — the AML implications become more material. If exchanges and regulators fail to address these risks, liquidity provision could become a significant weak point in the global financial crime framework. To prevent this, supervisory expectations for LP engagement must rise to a level comparable with the standards applied to other financial institutions. Only then can the benefits of liquidity provision be realized without compromising the integrity of the financial system.

References

• What are Liquidity Providers in Crypto
• 7 Best Crypto Liquidity Providers: Complete Guide for 2025

Liquidity Providers in the Crypto Market: Function, Risks, and AML Considerations was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.