An Overview On The State of Liquidity In Decentralized Finance (DeFi)

The nature of an asset’s liquidity is critical to understand for an investor, and it’s no different in the decentralized world of finance & investment.

As well, liquidity is a critical factor to the long-term success of exchanges, which help make up the infrastructure for buying & sharing crypto assets.

But what is liquidity, exactly?

And what’s the state of liquidity as it relates to DeFi, a crypto segment within which — as of today — more than $42 Billion USD is currently locked?

(If you aren’t sure what locked means in the context of DeFi, do take a look at this).

When one considers that — according to DeFi Pulse — this time last year the DeFi ecosytem’s collective TVL (Total Volume Locked) was “only” $558 Million USD, it begs the question:

What have been the key drivers to this exponential increase from $558 Million to more than $42 Billion?

In this post, I’ll be sharing findings related to liquidity.

My goal is that after reading this, you will have a solid overview of the following:

  • What liquidity is (and 3 key components involved in evaluating it)
  • How liquidity pools & providers form the backbone of DeFi

Let’s begin.

What is liquidity?

Liquidity measures the ease with which one asset can be converted into another with as little change to the asset’s price as possible.

There are 3 core aspects to consider when evaluating liquidity.

They are: slippage, spread & speed.

— What is slippage?

Slippage refers to the difference between the expected price of a trade and the actual price of a trade.

Let’s say you decide to purchase a coin with a fair market price of $5/coin.

You elect to carry out the transaction.

However, between the time you initiate the transaction and when the transaction is completed, the market price for the asset changes.

So, ultimately, you end up purchasing the coins for $5.04/coin.

This is slippage.

It may not seem like much, but imagine your order was for 10,000 coins.

Because of slippage, you’d be paying $400 more for the transaction.

When an exchange has a low number of coins available for purchase, slippage can become a problem. It can also be a problem when there’s a high level of volatility in a market or with respect to the asset.

We remember that liquidity measures our ability to transfer one asset to another with as little change to the price as possible.

In theory, an exchange with high liquidity would consist of more coins being available for purchase as well as a low level of price volatility for the coins.

If an exchange has a low level of liquidity for a particular asset, and one really wants that asset, one would have to decide whether they wanted to tolerate the (potential) slippage.

DeFi exchanges often allow one to adjust the level of acceptable slippage.

And because of the increase in DeFi TVL, decentralized exchanges are becoming more competitive with centralized exchanges as it relates to market making with low levels of slippage.

— OK, so what about spread?

Spread refers to the gap between the asking price of an asset and the selling price of an asset.

It’s not the same as slippage.

Slippage tells us the price movement after the order is made.

Spread tells us the difference in buyer and seller price preferences, before any order is made.

Larger spreads can signify a lower level of liquidity for an asset or an entire exchange. Centralized exchanges — at least historically —had been preferred over decentralized exchanges often due to offering better spreads.

However, AMMs (or, Automated Market Makers) have proven to be solid solutions — and critical infrastructure components — for someone interested in using a decentralized exchange within the DeFi ecosystem. AMMs rely on mathematical formulas to prices assets.

They are helping to ameliorate the spread problem, among other issues.

— And what about speed?

Speed refers to how fast a transaction for the trade of an asset can be conducted and confirmed.

Take for example a real estate asset.

If you own a home and decide to sell it, how likely is it that you can sell it at a fair price within the hour? Or, if you own stock in Tesla, could you trade it for its dollar equivalent in value in the next 30 minutes?

The speed at which a transaction can be processed depends on the type of asset, as well as the method by which the asset can be traded.

Transaction confirmation time has been a challenge for both Bitcoin (BTC) and Ethereum (ETH) — it’s on top of the Ethereum platform that the majority of the DeFi ecosystem is built — especially due to the manner in which transaction fees can rise quickly as the systems become congested.

However, block proposal pipelining is an example of a newer protocol-level development whereby once a block validator obtains two-thirds of the necessary signatures for a particular block, they may start proposing a new block. Simply put, this could allow for faster transaction confirmation times.

Individuals looking to make trades prefer speed — naturally — and would prefer not to encounter high-fees just to go from one asset to another.

Slower processing + Higher fees = Not a good place to liquidate (unless you reeeeaallly need to liquidate)

If the Ethereum platform gets badly congested, speed becomes a problem.

On the other hand, there is the aforementioned issue of price volatility in DeFi, and the speed at which prices can fluctuate.

Slippage, spread and speed are a package deal.

These 3 core aspects, together, can help with understanding the state of liquidity for a particular asset or an exchange in the crypto world.

This leads us to what is arguably the backbone of DeFi and why there’s been such an increase in TVL: liquidity pools & providers.

Photo by Avi Waxman on Unsplash

How Liquidity Pools & Providers Form The Backbone of DeFi

Exchanges need market makers.

And as discussed above, aspects like slippage, spread and speed are important to consider, because these 3 help with understanding the state of liquidity for a particular asset or an exchange.

In DeFi, the markets are (em)powered by Liquidity pools.

Liquidity pools are composed of liquidity providers.

And these combine with Automated Market Maker algorithms (AMMs) to present a novel solution in DeFi.

The automated market maker algorithms serve as the conduits so to speak, so that buyers and sellers can conduct their business in a trustless, frictionless manner.

And so that also, liquidity providers can be rewarded for providing the assets required to make the market.

But how does it work?

Essentially, when a token holder makes a deposit into a crypto liquidity pool (assuming the token is acceptable), a new token is automatically generated which represents the share the depositor owns of the pool.

It’s called a liquidity provider (LP) token, and there are often many potential uses for this token, both within the native platform as well as other decentralized finance apps.

One main use: for the depositor to receive a percentage of the platform’s transaction fees in proportion to how much of the pool the depositor owns.

All while retaining full custody of their crypto assets.

In this way, the assets required to make the markets is provided in a decentralized manner, but also the fees obtained by the platform are distributed in a decentralized manner.

But there is more.

Because there are multiple uses for the Liquidity Provider token (the LP token), liquidity within DeFi can be multiplied.

This same LP token can be staked and the token holder can be rewarded for this activity as well.

Let’s see this happen in 4 steps:

Step 1 — an individual hodling ETH provides liquidity to a pool by transferring their ETH into the pool; they are now a Liquidity Provider

Step 2 — the Provider receives an LP token (native to the platform) which represents ownership of the token as well as the ETH in the liquidity pool

Step 3 — the owner takes the LP token and “stakes” it within the native platform

Step 4 — the LP token holder earns a portion of fees for providing liquidity as well as for staking the LP token

This is the tokenization of verified ownership of a percentage of a liquidity pool where pool participants receive a share of fees for providing liquidity for a particular platform, and this token can be staked for additional rewards.

All the while, the Liquidity pool itself — in conjunction with an AMM — is enabling the buying and selling of digital assets.

Without the need for an intermediary.

DeFi is far from perfect, or even, optimal, but the amount of assets locked within the ecosystem has grown significantly within the last year.

And the infrastructure seems to be supporting a significantly more efficient, equitable and rewarding experience for finance & investment, as compared to traditional methods & routes.

And this seems to be only the beginning.

With the state of liquidity being a key component.

What are your thoughts on liquidity in DeFi? Did I miss any aspects? Can you provide additional clarity or insights on any of this?

Thanks for reading.

NOTE: This is not to be taken as investment advice of any kind. This post is fully for educational purposes.

Shooting for beyond the moon.