Remember when we compared "Price Discovery: Order Books and Automated Market Makers (AMMs)?" Let's dive deeper today and reflect further on the decentralized exchange (DEX) system, as it is the core that makes DeFi (Decentralized Finance) work.
AMMs utilize so-called "liquidity pools" to enable the trade of cryptocurrencies. It is an apt name since it reflects both the function (liquidity) and the structure (pool of assets). In other words, a liquidity pool is a shared pot of tokens that makes trading possible on decentralized exchanges between two (sometimes more) tokens. Although the term liquidity appears everywhere in finance and is of crucial importance for any marketplace, it has different meanings. Let's see how it differentiates and makes the pools "flow!"
In general, liquidity refers to the ability of any asset to be exchanged for cash. This allows for a differentiation of various assets according to their degree of liquidity: A stock market share of a company can easily be sold during market trading times, it is an asset with high liquidity. On the other hand, selling a property in real estate markets might take some time and is legally more complicated, resulting in low liquidity. In Finance, liquidity is therefore understood as a measure of how easily and quickly an asset can be bought or sold without affecting its price. Less well known, but of great importance in the corporate world, is another meaning of liquidity, namely the ability to meet one's payment obligations at any time. Either way, liquidity is a vital market characteristic because the degree of liquidity affects transaction speed as well as price movement.
In DeFi, a liquidity pool is a smart contract that holds tokens to enable trading without relying on traditional buyers and sellers. This contract allows for automated trading of digital assets by using a mathematical formula to price assets, thus it's called AMM. Instead of buyers and sellers, users deposit pairs of assets (tokens) into a trading pool. The incentive for providing liquidity to the pool is quite simple: You can earn money! Each trade that is made with the pool costs the trader a little fee, and all of these trading fees are split proportionally between all parties that have provided liquidity to the pool. In addition to fees, some protocols offer you extra tokens (usually the platform token) for providing liquidity to their trading pools. This practice is called "liquidity mining": Users will get additional incentives (tokens, NFTs, and/or voting rights) for providing liquidity.
Fees and incentives are used to motivate users to provide more liquidity. From a trader's perspective, this means: The higher the liquidity of a pool, the faster a trade at stable prices can be done. On the other hand, a pool with low liquidity correlates to slow trades with high price movements. For a liquidity provider, the dynamics of liquidity pools are as follows:
More liquidity provision means the size of the pool increases. This changes the percentage share of the earlier liquidity providers to the pool. In consequence, the proportional share of trading fees is reduced, but there might be a higher trading volume due to higher pool liquidity, for example, resulting in more trading fees.
Less liquidity leads to a shrinking pool size. Consequently, this means the individual percentage share of a liquidity provider to the pool is rising. You might earn a larger proportion of the trading fees, but there might be fewer trades overall and thus less fee income.
A further development of liquidity pools was originally introduced by Uniswap v3, a well-known decentralized exchange, and is called "concentrated liquidity pools". In contrast to a normal liquidity pool, where the liquidity is spread across the entire price range between the two pooled assets, a liquidity provider in a concentrated liquidity pool must select the price range where their liquidity is used. This leads to a higher capital efficiency and higher fees, but a strong dependence on the chosen price range.
Apart from fluctuating fee earnings, liquidity providers have to be aware of another critical risk connected to liquidity pools, called "impermanent loss". The term describes the fact that a liquidity provider in a DeFi pool may end up with a lower value of assets compared to simply holding the original tokens, due to changes in their price ratio while in the pool.
Let's use the metaphor of the art gallery once again to illustrate the concept figuratively, in the truest sense of the word. Our art gallery has two main showrooms, one dedicated to classical art, the other to modern art. The owners of art (our liquidity providers) bring in their art pieces to display. In order to create a balanced and diverse collection, they contribute to both rooms. Visitors of the gallery (our traders) can now come in and exchange their art pieces, e.g., selling a classical painting for a modern one (trade USDC for ETH).
This exchange is facilitated by our art gallery (Decentralized Exchange), which is using the art pieces in its collection. As an incentive for those art owners who contributed to the gallery, they earn a commission from each sale. The more art pieces are shown in both rooms, the easier it will be for visitors to exchange their own art objects for something else (high liquidity). Conversely, if the gallery is showing just a few pieces, a visitor might not find the right art piece to exchange (low liquidity).
To wrap it up, liquidity pools are combining two different tokens (styles of artwork) with the goal of facilitating exchange of valuable assets (artwork swaps). High liquidity of a pool means large volumes of buyers and sellers and minimal price fluctuations. If the level of liquidity is low, it is much harder to trade, and any token exchange will cause a higher asset price shift. In DeFi, the provision of liquidity is rewarded and sometimes incentivized. Still, it comes at the risk of impermanent loss that arises whenever asset prices move relative to each other after deposit, and is most severe for volatile asset pairs.
Happy Week, ALANA Adventurers!
This article was authored by Nils Otter, a DAO member of The ALANA Project.
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Liquidity is really crucial.