What Does Providing Liquidity Mean in Crypto?
Sep 19, 2022
The term "liquidity" is one you hear most when dealing with the crypto market. Liquidity can significantly affect investors' ability to get a fair exchange rate for their cryptocurrency holdings.
There's been a surge in interest and activity in the DeFi (decentralized finance) industry in recent years. A vital component of this achievement is liquidity mining, which is seen as a great way to bootstrap the liquidity of crypto assets.
But how does liquidity work in the world of cryptocurrencies? In this article, we will talk about what providing liquidity in crypto means, how it works in DeFi, and how to increase the liquidity of certain tokens or crypto exchanges.
What is Liquidity?
Liquidity refers to the speed at which an investment may be sold without adversely affecting its value. An investment that is more liquid can be sold easier and faster for a fair price. The price of liquid assets tends to be higher than that of illiquid assets.
Since cash (or other means of exchange) is easily convertible into other assets, it can be considered the most liquid asset. In the cryptocurrency market, stablecoins play this role.
Residential property, expensive and rare items or products, in contrast, may be considered illiquid because they aren't easy to buy or sell. An individual who owns a rare piece of art may have difficulty finding a buyer at a price he considers fair in the marketplace.
When it comes to digital exchanges and cryptocurrencies, assets are bought or sold by moving bits around in computers. As a result, making a transaction is relatively easy, which provides extra benefits to liquidity.
Why is liquidity important for the cryptocurrency market?
Financial markets are reliant on liquidity. The delay between the time you get your order matched by another trader could be hours or even days if you trade on low-liquidity markets.
Depending on the market, the trading volume could range from a few thousand dollars to billions per day. For cryptocurrencies like Bitcoin and Ethereum, liquidity isn't an issue, but for many other coins, the market could lack liquidity significantly.
The importance of this is particularly evident when trading altcoins. If you build up a position in an illiquid coin and cannot sell it at the price you want, you may lose money. Therefore, trading liquid assets is generally more advantageous.
A large order placed in an illiquid market can result in unexpected consequences, such as slippage, which occurs when markets have low liquidity or high volatility. You can think of it as the difference between your intended price and the price where your trade was executed. If you have a high slippage, your trade will be executed at a very different price than what you expected. If you are experiencing this issue, it is because there aren't enough orders in the order book that are close to where you would like them to be executed.
Slippage has become a common occurrence with automated market makers and decentralized exchanges. It is possible for an altcoin to slip over 10% of its expected price if it is volatile or has low liquidity. The best way to reduce slippage is to increase the liquidity of an asset.
There are more buyers and sellers in a market with high liquidity, and so the prices are better for every participant. High levels of trading activity in an active marketplace tend to create an equilibrium market price that is acceptable to all.
It is essential to have a high level of liquidity in order to execute orders quickly. Whenever there are a lot of sellers and buyers, platforms execute trades and orders fast.
Liquidity Pools and Liquidity Mining: How Do They Work?
Thanks to modern technologies and blockchain, the DeFi industry offers decentralized methods and schemes on how to increase the liquidity of certain crypto assets. One such scheme is a liquidity pool, which is commonly used for powering liquidity in DEXes.
But what is DEX?
There are two main models of exchanges in the crypto industry: centralized (CEX) and decentralized (DEX). A CEX operates through an intermediary who handles trades and monitors assets. Unlike CEXes, a DEX does not include a third party, and the assets are held by the participants, not by a financial institution.
The order book is the foundation on which centralized exchanges and traditional financial trading platforms are built. The order book is a list of orders used by trading venues to record interest in financial instruments from buyers and sellers. A matching engine, which is a core of every centralized trading venue, uses the order book to determine which orders can be fully or partially executed.
This model allows for the creation of complex financial markets and facilitates efficient exchange.
The DeFi model, however, involves trading on-chain without the use of a centralized party to hold funds. And this is where liquidity pools come into play.
How does the liquidity pool work?
Basically, liquidity pools are smart contracts where crypto investors can deposit tokens (2 tokens with the same value) to earn a return. Many decentralized exchanges, like Uniswap, are built on liquidity pools.
The main role in the liquidity pools is played by automated market makers (AMMs). This is a kind of decentralized exchange protocol that utilizes a mathematical formula to determine the price of assets. As opposed to centralized exchanges, assets are priced according to algorithms instead of order books.
AMMs allow you to execute trades without having to deal with a counterparty in the traditional sense. Rather, you target liquidity in a liquidity pool when you execute a trade. It is not necessary for the buyer to find a seller; only adequate liquidity is needed in the pool to complete the transaction.
Who are liquidity providers in liquidity pools?
Users, who deposit their funds to liquidity pools, are called liquidity providers (LP). Sometimes they are also referred to as market makers. In order to create a market, they add two tokens worth equal value to a pool.
The main motive of liquidity providers is to make a passive income in this process. In return for contributing funds, LPs earn trading fees on the trades that take place in the pool, proportional to the amount of liquidity they contribute to it.
Pooling liquidity is a profoundly simple concept, so it is used in a number of different ways, one of which is liquidity mining.
What is Liquidity Mining?
Among investors, crypto liquidity mining has become increasingly popular over the past few years due to its ability to yield rewards without requiring active investment decisions. The total compensation you receive depends on your share in the liquidity pool.
It is essential to understand that liquidity mining and yield farming are both related, and some investors sometimes use the terms interchangeably. However, they are not the same. The main difference between these two models is that investing in liquidity mining allows an investor to earn native tokens, and investments in yield farming allow that investor to earn interest.
The concept of liquidity mining gained popularity in June 2020, but it had existed for years before then. One of the most popular decentralized exchanges, IDEX, first defined the concept in 2017. In the following three years, Uniswap and Compound refined the idea.
Compound announced DeFi liquidity mining in 2020, and it gained rapid traction. According to numbers, the total value locked (TVL) of all crypto assets has grown to about $87 billion since then.
Benefits of Liquidity Mining
Liquidity mining can be seen as passive income for investors. Liquidity providers can trade obtained tokens on exchanges in order to generate additional revenue.
Getting in is easy
Along with the equal distribution of rewards to investors, DeFi liquidity mining also has a relatively low barrier to entry. Liquidity mining offers both small retail and institutional investors an equal chance of owning native tokens of a specific protocol.
A vital component of the liquidity of an economy is the liquidity of funds. A decentralized fund pool model that provides a valuable and innovative way to pool funds, along with comprehensive user incentives via the interest rate mechanism, generates liquidity in certain assets and the crypto market in general.
Increasing the effectiveness of marketing strategy
As a result of liquidity mining, projects are able to attract press coverage and raise greater awareness. Liquidity mining budgets must be carefully managed throughout the campaign.
Risks of liquidity mining
Liquidity pools are an excellent place to invest your cryptocurrency, but you should understand how impermanent losses can affect you. Impermanent loss happens when the price of your tokens changes compared to when you deposited them in the pool. Losses increase with the size of the change.
If there is a bug or some exploit with smart contracts, your funds could be lost forever. So investors need to do their research on projects they are investing in.
While decentralized investing offers many advantages, some inherent risks may arise due to the nature of the system. A potential danger is "rug pulls," which happen when liquidity pool developers or protocol developers intend to take all the money invested in a project by shutting it down.
How to Provide Liquidity to Crypto Exchange?
Institutional liquidity providers
Cryptocurrencies and traditional financial markets both require liquidity for success. This is why centralized exchanges often work with crypto liquidity providers who provide institutional liquidity.
Institutional liquidity providers are third-party companies that actively participate in the crypto market on both sides. One of the main reasons that these companies exist is to ensure that digital assets can be sold faster to a broader market. The term crypto market maker can also be used to refer to them. Market makers quote both the sale and purchase price of an asset to provide liquidity. Most of the time, these companies trade on multiple platforms simultaneously, sourcing liquidity at one platform and executing trades at another.
Also, as some exchanges want to give their traders the opportunity to trade with crypto CFD contracts, owners of these platforms are turning to crypto CFD liquidity providers that can supply them with this type of liquidity.
Interexchange market making
An exchange operator may take on the role of providing liquidity himself, eliminating the need for third parties.
As a market maker, an exchange operator is responsible for setting the prices of assets at their own venue. The exchanges do this by adding a markup to prices they take from other exchanges, known as takers or source exchanges.
Through this method, venue operators have access to liquidity without having to pay a third party. However, it is not very efficient in terms of capital. Trading venues can't use capital for other profitable purposes or often rebalance between exchanges if they engage in cross-exchange market making.
When DEXs attempted to model the traditional market makers in the early stages of DeFi, they faced crypto market liquidity issues. By encouraging users to provide liquidity rather than allowing sellers and buyers to match in order books, liquidity pools helped solve this problem. Providing a robust, decentralized liquidity solution helped the DeFi sector grow. Although liquidity pools were born out of necessity, their technology presents a fresh way of providing decentralized liquidity algorithmically by financing pools of incentivized assets.
The cryptocurrency industry faces many challenges when it comes to providing liquidity. Various strategies have benefits and drawbacks. Liquidity mining appears simple at first glance, but it is actually an extremely powerful tool. Before entering the DeFi ecosystem, investors should carefully consider and assess their aims and expectations. In addition, it is essential for users to understand the entire ecosystem thoroughly and, most importantly, choose a sophisticated protocol that will allow them to maximize liquidity mining opportunities.
And if you are an exchange owner, having access to credit lines and attractive quotes makes partnering with third-party market makers the best solution. There are many options on the market, so be sure to look around and compare different possible providers to make an educated decision.