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Liquidity & Liquidity Pools

Defination

The term liquidity is generally used in the financial markets to describe the ease by which an asset can be converted into cash without difficulty. In terms of cryptocurrencies, liquidity is the ability of a coin to be easily converted into cash or other coins.

Low liquidity levels mean that market volatility is present, causing spikes in cryptocurrency prices. High liquidity, on the other hand, means there is a stable market, with few fluctuations in price.

Another view is that liquidity is determined by the bid-ask spread, and an investment with a lower bid-ask spread has higher liquidity. Liquidity thus means that there aren’t discounts or premiums attached to an asset during buying or selling, and it is easy to enter and exit the market.

Factors affecting Liquidity

Trading volumes (cryptocurrency market cap)

Usability (like payment)

Regulations

Issue/Needs

For example,

if Enzo is a buyer, and Gareth is Seller.

While Enzo wants to buy the coin for a low pirce, like $9

But Gareth wants to sell the coin for a higher price, like $11

And no one is willing to buy/sell for $10

Here comes market marker Irene helps facilitates the trading, and Irene always willing to buy or sell an asset, which, provides liquidity

So Enzo/Gareth could exchange with Irene

And Irene track/changing the price constantly, which huge number of orders. And Ethereum’s gas fee is sooooo high, so she would go bankrupted by updating orders.

So, if we can reduce the fee, like a layer 2 solution:

But we have 2 extra steps, since layer 2 needs to interact with the mainnet, and it takes a relatively long time. (Time is important for market makers)

Damn, then we invented liquidity pool as a solution.

Solution【Comments from Enzo】

Irene invented Uniswap, which holds two tokens, DAI & ETH = a new pool

Irene = 1st liquidity provider (LP)

As a LP, she funds a liquidity pool with crypto assets she owns to facilitate trading on the platform and earn passive income on her deposit.

Irene sets the first initial value, and she is incentivised to equal value of DAI & ETH

Since DAI & ETH price diverges in global market, so there are people take arbitrage, while cause lost capital for LP

Irene receives LP tokens in proportion to liquidity

Ex: 0.3% of fee will be proportionally distributed to Irene and other LPs.

What if Irene wants to get her liquidity back?

She has to burn the LP tokens

Token Swap price?

It is determined by deterministic algorithm, which is AMM (Automated Market Maker)

What is the algorithm of Uniswap?

#Token1 * #Token2 = constant k

Why the ratio of tokens influence the price?

Like the amount of DAI&ETH is fixed in the pool, if Enzo buy x ETH

then the #ETH ⬇️ & #DAI ⬆️

while $ETH ⬆️ & $DAI ⬇️

The change in $ is based on the change in size of the trade and size of the pool

What if the pool size is large?

Less slippage, the price won’t fluctuate too much, better trading experience, no more centralize order book.

Order book model

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An order book is a list, typically electronic, of buy (bid) and sell (offer) orders, including the number of shares to be bought or sold. The order book is organized by price level. This helps keep track of the level of interest for a tradable instrument and shows the market depth.

The order book helps traders become more informed about the trades they make by allowing them to analyze current buy and sell activity. Using an order book to make informed decisions about trades enables investors to increase their likelihood of making a successful trade.

Defination

A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (DEX). Instead of traditional markets of buyers and sellers, many decentralized finance (DeFi) platforms use automated market makers (AMMs), which allow digital assets to be traded in an automatic and permissionless manner through the use of liquidity pools.

The Role of Crypto Liquidity Pools in DeFi

Liquidity pools are a mechanism by which users can pool their assets in a DEX’s smart contracts to provide asset liquidity for traders to swap between currencies. Liquidity pools provide much-needed liquidity, speed, and convenience to the DeFi ecosystem.

Before automated market makers (AMMs) came into play, crypto market liquidity was a challenge for DEXs on Ethereum. At that time, DEXs were a new technology with a complicated interface and the number of buyers and sellers was small, so it was difficult to find enough people willing to trade on a regular basis. AMMs fix this problem of limited liquidity by creating liquidity pools and offering liquidity providers the incentive to supply these pools with assets, all without the need for third-party middlemen. The more assets in a pool and the more liquidity the pool has, the easier trading becomes on decentralized exchanges.

Why Are Crypto Liquidity Pools Important?

Any seasoned trader in traditional or crypto markets can tell you about the potential downsides of entering a market with little liquidity. Whether it’s a low cap cryptocurrency or penny stock, slippage will be a concern when trying to enter — or exit — any trade. Slippage is the difference between the expected price of a trade and the price at which it is executed. Slippage is most common during periods of higher volatility, and can also occur when a large order is executed but there isn't enough volume at the selected price to maintain the bid-ask spread.

This market order price that is used in times of high volatility or low volume in a traditional order book model is determined by the bid-ask spread of the order book for a given trading pair. This means it’s the middle point between what sellers are willing to sell the asset for and the price at which buyers are willing to purchase it. However, low liquidity can incur more slippage and the executed trading price can far exceed the original market order price, depending on the bid-ask spread for the asset at any given time.

Liquidity pools aim to solve the problem of illiquid markets by incentivizing users themselves to provide crypto liquidity for a share of trading fees. Trading with liquidity pool protocols like Bancor or Uniswap requires no buyer and seller matching. This means users can simply exchange their tokens and assets using liquidity that is provided by users and transacted through smart contracts.

How Do Crypto Liquidity Pools Work?

An operational crypto liquidity pool must be designed in a way that incentivizes crypto liquidity providers to stake their assets in a pool.

That’s why most liquidity providers earn trading fees and crypto rewards from the exchanges upon which they pool tokens. When a user supplies a pool with liquidity, the provider is often rewarded with liquidity provider (LP) tokens. LP tokens can be valuable assets in their own right, and can be used throughout the DeFi ecosystem in various capacities.

Usually, a crypto liquidity provider receives LP tokens in proportion to the amount of liquidity they have supplied to the pool. When a pool facilitates a trade, a fractional fee is proportionally distributed amongst the LP token holders.

For the liquidity provider to get back the liquidity they contributed (in addition to accrued fees from their portion), their LP tokens must be destroyed.

Liquidity pools maintain fair market values for the tokens they hold thanks to AMM algorithms, which maintain the price of tokens relative to one another within any particular pool. Liquidity pools in different protocols may use algorithms that differ slightly. For example: Uniswap liquidity pools use a constant product formula to maintain price ratios, and many DEX platforms utilize a similar model. This algorithm helps ensure that a pool consistently provides crypto market liquidity by managing the cost and ratio of the corresponding tokens as the demanded quantity increases.

Yield Farming and Liquidity Pools

To create a better trading experience, various protocols offer even more incentives for users to provide liquidity by providing more tokens for particular “incentivized” pools. Participating in these incentivized liquidity pools as a provider to get the maximum amount of LP tokens is called liquidity mining. Liquidity mining is how crypto exchange liquidity providers can optimize their LP token earnings on a particular market or platform.

There are many different DeFi markets, platforms, and incentivized pools that allow you to earn rewards for providing and mining liquidity via LP tokens. So how does a crypto liquidity provider choose where to place their funds? This is where yield farming comes into play. Yield farming is the practice of staking or locking up cryptocurrencies within a blockchain protocol to generate tokenized rewards. The idea of yield farming is to stake or lock up tokens in various DeFi applications in order to generate tokenized rewards that help maximize earnings. This allows a crypto exchange liquidity provider to collect high returns for slightly higher risk as their funds are distributed to trading pairs and incentivized pools with the highest trading fee and LP token payouts across multiple platforms. This type of liquidity investing can automatically put a user's funds into the highest yielding asset pairs. Platforms like Yearn.finance even automate balance risk choice and returns to move your funds to various DeFi investments that provide liquidity.

The Unexpected Value of Crypto Liquidity Pools

In the early phases of DeFi, DEXs suffered from crypto market liquidity problems when attempting to model the traditional market makers. Liquidity pools helped address this problem by having users be incentivized to provide liquidity instead of having a seller and buyer match in an order book. This provided a powerful, decentralized solution to liquidity in DeFi, and was instrumental in unlocking the growth of the DeFi sector. Liquidity pools may have been born from necessity, but their innovation brings a fresh new way to provide decentralized liquidity algorithmically through incentivized, user funded pools of asset pairs.

Bibliography:

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https://www.gemini.com/cryptopedia/what-is-a-liquidity-pool-crypto-market-liquidity⁠

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https://www.youtube.com/watch?v=cizLhxSKrAc&ab_channel=Finematics⁠

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https://b2broker.com/news/cryptocurrency-liquidity-and-finding-the-best-liquidity-provider/⁠

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https://www.investopedia.com/articles/investing/112914/liquidity-bitcoins.asp⁠

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