The Importance Of Liquidity In Decentralized Finance (DeFi)

Liquidity is one of the most important aspects of every market and asset. The main reason liquidity is so important is that it greatly affects asset prices. In simple words, liquidity is the ability to buy or sell assets in the market without causing a drastic change in the assets’ price.

Liquidity pools are the backbone of many decentralized exchanges, such as Uniswap. A liquidity pool is a collection of funds locked in a smart contract and used to facilitate decentralized trading, lending and more.

A liquidity pool is nothing more than an automated market maker that provides liquidity to avoid large price swings for an asset. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity. Anyone can be a liquidity provider and automated market makes (AMMs) like Uniswap have made market making more accessible.

The difference between a liquidity pool and an order book

The order book is a collection of the currently open orders for a given market. People put limit orders (sell or buy orders) at specific prices and with specific amounts and this consists of the order book. The system that matches orders with each other is called the matching engine. Along with the matching engine, the order book is the core of any centralized exchange (CEX). You could think of an order book exchange as peer-to-peer, where buyers and sellers are connected by the order book.

DeFi trading, however, involves executing trades on-chain, without a centralized party holding the funds. This presents a problem when it comes to order books. Each interaction with the order book requires gas fees, which makes it much more expensive to execute trades. This means that on a blockchain like Ethereum, an on-chain order book exchange is practically impossible. You could use sidechains or layer-two solutions, and these are on the way. However, the network isn’t able to handle the throughput in its current form.

Automated market makers (AMM) have changed this game. They are a significant innovation that allows for on-chain trading without the need for an order book. As no direct counterparty is needed to execute trades, traders can get in and out of positions on token pairs that likely would be highly illiquid on order book exchanges. You could think of trading on an AMM as peer-to-contract. When you’re executing a trade on an AMM, you don’t have a counterparty in the traditional sense. Instead, you’re executing the trade against the liquidity in the liquidity pool. For the buyer to buy, there doesn’t need to be a seller at that particular moment, only sufficient liquidity in the pool.

When tokens are deposited into a crypto liquidity pool, the platform automatically generates a new token that represents the share the depositor owns of that pool. This is called a liquidity provider (LP) token, and it can be used for a multitude of functions both within its native platform and other decentralized finance apps. LP tokens allow AMMs to be non-custodial, meaning they do not hold on to your tokens, but instead operate via automated functions that promote decentralization and fairness.

If you provide liquidity to an AMM, you’ll need to be aware of a concept called impermanent loss. Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit. Ιmpermanent loss can still be counteracted by trading fees. In fact, even pools on Uniswap that are quite exposed to impermanent loss can be profitable thanks to the trading fees.

Liquidity Mining

And this is where liquidity mining protocols come in. A number of protocols decided to give extra rewards to Liquidity Providers (LPs) by adding a traditional yield and their governance tokens in the mix. This gives an extra incentive to LPs as they earn an additional stream of income. They can stake their LP tokens and earn rewards on top of the LP fees. Moreover, they receive a stake in the protocol by being able to participate in governance. By doing so, they can change the protocol, how it works, and even add more liquidity pools.

Liquidity mining protocols come in all shapes and sizes. Each individual protocol is unique and offers its own distinctive features and reward distribution types. But there is one notable mention that wants to bring something new. AquaFi, built by Blockzero Labs, plans to be a universal liquidity mining protocol, with the goal to aggregate all the Decentralized Exchanges in the decentralized world and give Liquidity Providers an additional lego to stack their yield.

(Disclaimer: The author of this story is a Community Manager at BlockzeroLabs)

In simple words, the AquaFi Protocol allows Liquidity Providers to stake their LP tokens and for that, it pays them a premium, by keeping the LP fees and paying them with the governance token of the protocol, AQUA, at a higher rate than they would have had if they didn’t use AquaFi. It offers a simple way to optimize your LP rewards and earn up to 100% more fees on your LP tokens.

It’s becoming more and more clear that decentralized AMM’s are the future of trading, and the market size and yield potential are only going to increase. Liquidity is continuing to migrate from centralized exchanges to decentralized exchanges, which may mark the start of a new paradigm in cryptocurrency markets.

Liquidity pools are one of the core technologies behind DeFi. They enable decentralized trading, lending, yield generation, and much more. These smart contracts power almost every part of DeFi, and they will most likely continue to do so.

(Disclaimer: The author of this story is a Community Manager at BlockzeroLabs)