Understanding Liquidity in DeFi

Everything you need to know about DEXs, AMMs, and LPs in an easy way

What is Liquidity?

Liquidity is at the heart of any market.

It refers to the possibility of buying or selling any asset without affecting prices.

Money is the most liquid asset. You can always exchange money for other assets, goods, and services.

By contrast, Real Estate is illiquid.

Exchanging your house for assets, goods, or services is complicated.

You would probably have to sell your home to exchange it for other assets, goods, or services.

Liquidity in DeFi

Liquidity is important because it makes DeFi usable.

Let’s say you want to exchange 1 ETH for $1,200 USDC.

• If there is no USDC available in the market, you certainly wouldn’t be able to make the trade. 🙅‍♂️
• If there is only $600 USDC, you would have to pay more ETH to get your USDC.

This problem is known as slippage.

Whales and institutional investors always face the slippage problem when they want to trade large amounts of assets.

More liquidity in DeFi means less slippage, allowing big and small investors to enter the DeFi market.

Trading with Order Books

Let’s go back to the ETH and USDC example.

To execute the trade, you need to find one or more users willing to buy your ETH at $1,200.

Centralized exchanges (CEXs) such as Binance and Coinbase do the work of matching buyers and sellers.

Buyers’ and sellers’ bids are placed in order books. When buy and sell prices match, the CEX executes the trade for you.

In this case, liquidity comes from the bids from buyers and sellers.

Why are there no order books in DeFi?

The first DeFi builders tried — but failed.

Using order books in a blockchain is not functional at all.

Blockchains transactions are costly and slow, so matching buyers and sellers’ orders would be too expensive.

DeFi builders had to look for a new and solid method for allowing users to trade on-chain.

Introducing Liquidity Pools (LPs)

Liquidity Pools (LPs) are one of the main DeFi innovations.

They allowed users to exchange tokens in a simple and decentralized manner through Decentralized Exchanges (DEXs).

Instead of matching buying and selling order bids, they incentivized users to provide liquidity to a pot of tokens.

For example, the USDC/ETH pool on Uniswap.

To provide liquidity, the user has to deposit USDC and ETH in the pool in the same proportion.

As a reward, they earn a percentage of trading fees.

Uniswap, for example, gets a 0.3% fee for every transaction, which is then paid to liquidity providers.

This fee mechanism incentives liquidity to stay in the pool. This way, traders can exchange their tokens smoothly.

The token exchange is executed through smart contracts without a centralized entity — everything runs on-chain, from wallet to wallet.

This mechanism of liquidity pools and automatic trades receive a fancy name: Automated Market Maker (AMM).

Providing liquidity is one of the best ways to generate passive income in DeFi. 👌

Liquidity Pool Tokens (LP Tokens)

Besides this automated trading mechanism, AMMs also bring another cool innovation: LP Tokens.

You receive an LP token in your wallet whenever you provide liquid on a DEX.

For example, an “ETH-USDC-LP” token.

An LP token represents a share of the liquidity pool. You will have to exchange the LP token if you want your ETH and USDC back.

What makes LP tokens special is that you can trade, transfer and even get more yield on your LP token.

This is good for DeFi because it makes the market more liquid, as liquidity doesn’t get locked into the liquidity pool.

For users, this is a compelling DeFi use case:

• The user fully controls his funds, as the LP token is in his wallet.
• It’s possible to unlock even more yields with the LP token.

Final Remarks

Now you may better understand the importance of liquidity in DeFi.

Liquidity means a more efficient market, where users can trade with fewer slippage concerns.

DeFi has made a big step by introducing Liquidity Pools (LPs) and Automated Market Makers (AMMs) on the blockchain.

Those two technologies allowed liquidity to flow into DeFi while making trading directly on a blockchain a reality for hundreds of thousands of users.

One of the most remarkable innovations of AMMs is the LP tokens, which give users control of their assets while making them more liquid.

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