If you’re investing in crypto, especially using decentralized finance platforms, you should understand liquidity and how it works in various financial products.
In this article, we’ll analyze the main points:
- What is liquidity in crypto?
- Where does liquidity come from, and how does it work?
- What are the risks associated with the lack of liquidity?
- How do liquidity providers make money?
- What are the best liquidity pools?
Let's get started!
Crypto Liquidity Meaning
According to Investopedia, liquidity refers to the ease with which an asset or security can be converted into ready cash without affecting its market price.
In terms of crypto, liquidity has the same meaning. Crypto liquidity relates to how easily and quickly any digital asset can be bought or sold without causing significant price changes. High liquidity means a large volume of buyers and sellers, allowing them to exchange crypto at a stable price easily.
Most blue chip assets, like BTC, ETH, and SOL, usually have high liquidity. Less-known tokens or coins can experience a lack of liquidity, which means they can still be sold or bought, but this can affect their price significantly, especially with large trading amounts.
Typically, liquidity depends on the following factors:
- Market Makers can continuously buy and sell assets to provide liquidity in the market and help maintain liquidity. They make a profit on the bid-ask spread.
- Trading Volume: the more traders buy or sell, the more liquid the asset.
- Listings: assets listed on different exchanges tend to be more liquid.
How Does Crypto Liquidity Work? Liquidity Pools, Liquidity Providers, Slippage
Any crypto protocols that allow trading, bridging cryptocurrencies between networks, liquid restaking, etc., require liquidity. However, there is a difference between how CeFi (Centralized Finance) and DeFi (Decentralized Finance) products work.
Liquidity for CeFi products is often provided by institutional clients: market makers, institutional traders, specialized liquidity providers, aggregators, and the exchange's own reserves. Users' funds received through the relevant products – lending, staking, etc. – can also be used for this purpose. All these entities can be liquidity providers.
Centralized crypto protocols, primarily large exchanges, usually only list tokens that meet their criteria, including the ability to provide liquidity and work with market makers.
DeFi protocols can also use the services of institutional liquidity providers. However, users can initiate trading pairs and provide liquidity for trading. For this purpose, the AMMs (Automated Market Makers) have been developed.
AMMs play a crucial role in the functioning of decentralized exchanges (DEXs). Unlike centralized exchanges (CEXs), which depend on traditional order books, AMMs enable users to seamlessly trade cryptocurrencies from their wallets.
These trades are made possible through liquidity pools and smart contracts, which automate and decentralize the trading process, eliminating the need for intermediaries and making the system more efficient and accessible.
At the heart of an Automated Market Maker (AMM) lies the concept of liquidity pools. Unlike traditional order book systems, where buyers are matched with sellers, AMMs rely on token pools locked within smart contracts. These liquidity pools, supplied by users known as liquidity providers (LPs), consist of token pairs like ETH/USDC. When trading on a decentralized exchange (DEX) using an AMM, you interact with the liquidity in these pools rather than executing trades directly with another individual.
For example, if a user wants to buy ETH with USDC, they deposit USDC into the liquidity pool, and ETH is withdrawn based on the AMM's pricing algorithm. The price changes based on the slippage of the trade, which depends on the trade's size relative to the pool's total liquidity. The larger the trade relative to the pool size, the more the price shifts.
Slippage is the disparity between the anticipated price of a trade and the actual price at execution. This typically occurs when large trades are made within a smaller liquidity pool, leading to notable price fluctuations. Larger liquidity pools help minimize slippage, which is why AMMs encourage users to provide liquidity to maintain price stability.
Slippage is one of the main risks associated with illiquid, or low liquid markets. Always pay attention to this indicator when executing trades.
Best Crypto Liquidity Pools
Investors in cryptocurrencies can act as liquidity providers and earn interest. On decentralized exchanges, users can add liquidity to different pairs of tokens and earn a portion of fees each time traders trade in this pair.
Another option is to deposit liquidity in lending, yield farming, or any other protocols that work with liquidity. It’s possible to use even one token here. The protocols will earn money by using your liquidity, for example, by lending it to borrowers or supplying it to other institutions.
How to choose the best liquidity pool? Pay attention to the APR, the rate of return you can earn over a year from lending or providing liquidity. Very often, new platforms offer a higher APR to attract users, but at the same time, they can be more risky. To hedge against this risk, choose protocols with a history, security audits, a proven business model, users, etc.
Key Factors When Choosing the Best Liquidity Pools
- Trading Volume:
Liquidity pools with higher trading volume typically provide greater returns, as more frequent transactions generate more fees for liquidity providers.
- Impermanent Loss:
To minimize the risk of impermanent loss, consider liquidity pools with stablecoins or low-volatility assets, which tend to be more stable than volatile cryptocurrency pairs.
- Rewards and Incentives:
Prioritize platforms that offer additional incentives, such as yield farming or liquidity mining, to enhance your overall earnings as a liquidity provider.
- Fee Structures:
Certain platforms, like Uniswap V3, implement dynamic fee models, which can be more profitable for liquidity providers in active, high-volume markets.
Also, use such tools only if you clearly understand how to use them and where your income will come from. Most decentralized protocols offer floating interest rates based on supply and demand. A good APR today can become relatively insignificant tomorrow, so you need to regularly monitor your position's performance. If you prefer predictable returns, check out Qonstant, a fixed-rates lending protocol on Arbitrum.
The most well-known decentralized liquidity platforms include the following: Uniswap, Sushiswap, Pancakeswap, Jupiter, Jito, Aave, Aerodrome, Balancer, Curve, Beefy, and others.
It’s crucial to note that liquidity provision is a riskier way of investing than a simple token holding, as it requires depositing cryptocurrencies on an exchange or their lock in smart contracts that can become objects of exploits (DEXs, lending protocols, etc.) or bankruptcy (CEXs, for example, the FTX case).
Conclusion
Understanding liquidity, where it comes from, how it works, and how you can make money by supplying liquidity is one of the basic elements in investing in cryptocurrencies. If you’re curious to know more, join us on social media and subscribe to our newsletter to learn more about DeFi and the financial services we build.