Liquidity in Crypto
What is it? Who has it? How will Polkaswap make it “boundless”?
The term liquidity isn’t specific to crypto, but it’s an important concept in the crypto world. This post will provide insights into liquidity within centralized exchanges, decentralized exchanges, and specifically, Polkaswap. So let’s start with Liquidity: what is it?
A highly liquid asset is one that can be easily sold (liquidated) at its fair market value, whereas an illiquid asset is one that can’t be sold without significant effort, a loss of value, or both. Similarly, a highly liquid market for a particular asset is one with lots of (fair) buy and sell orders circulating.
Equities listed on major exchanges, for instance, are often highly liquid: they can be sold quickly, and the difference between the bid and ask prices will be small. A rare artwork, on the other hand, is illiquid: finding a buyer willing to bid near your ask price will take effort. Of course, an auction house will be a more liquid market for a Van Gogh than a street corner. In the fiat world, cash mediates the flow of value between assets: you can easily sell one painting to buy another, whereas swapping them would often be tricky. This is the medium of exchange property of money.
Liquidity on centralized crypto exchanges (CEXs)
What about the crypto world? The basic rule is the same: the liquidity of a given token is a function of the number of buy and sell orders on the books. As tokens are swapped as well as sold, we talk about the liquidity of trading pairs as well as individual tokens. Centralized exchanges (CEX), which maintain custody of their users’ tokens, record buy and sell orders in a digital order book and match the former to the latter. Like a brokerage, a CEX will generally charge a fee on each match. They often use fee scales to attract large-volume traders (known as market makers) who provide liquidity by putting orders in their books. Network effects also come into play here: an exchange with high liquidity will offer narrower bid-ask spreads, attracting more volume and further upping liquidity.
Liquidity on decentralized exchanges (DEXs)
Historically, these factors have given CEXs a liquidity edge over decentralized exchanges or DEXs. CEXs, however, have a few drawbacks. First, they limit traders to token pairs defined from the top down. Second, some users would prefer to keep custody over their tokens throughout the trading process. Centralization also entails security risks: like a bank, a CEX is a big, fat prize for anyone clever enough to break in. Finally, while some CEXs pay interest on crypto held, the profit-making opportunities for everyday traders are limited. For traders who value autonomy and security or who want to put their assets to work, new technologies make DEXs increasingly attractive.
On a DEX, users maintain custody of their tokens and provide liquidity themselves. As we hinted at in a past article, they do so by contributing tokens to a liquidity pool: a pile of tokens bound together by a smart contract. Usually, each trading pair — for example, ETH/XOR — will have its own pool; the exchange rate for the pair is set automatically, based on supply and demand by the smart contract managing the pool. Rather than accruing solely to the exchange, trade fees are distributed by the contract to the users holding tokens in the pool. This is one reason the value locked into pools on DEXs has grown around 3000% over the past 12 months.
Boundless liquidity across multiple blockchains
For the time being, as the trading volume of the top DEXs is still a fraction of that of the top CEXs, the latter still holds a liquidity advantage. However, the next generation of DEXs — led by Polkaswap — will flip the script through technologies like Liquidity Aggregation and cross-chain interoperability.
A liquidity aggregator is a protocol that identifies and accesses liquidity across multiple exchanges. Some protocols aggregate liquidity across DEXs, and some across CEXs. Polkaswap can query both types of exchange: smart liquidity routing will allow Polkaswap to match your trade request to the liquidity source offering the best rate. Another distinguishing feature of Polkaswap is cross-chain interoperability: it will take advantage of blockchain bridges to access an unsurpassed range of tokens. The SORA XOR token will act as Polkaswap’s “cash”, similar to how ETH works on Uniswap — but, because Polkaswap’s Substrate framework scales more efficiently than Ethereum, gas fees will be lower even as trade volume grows.
What’s in it for my wallet?
Smart liquidity routing, cross-chain interoperability, and a more scalable architecture will be beneficial to your wallet and the ecosystem alike, as they will help make trading across many exchanges more competitive and efficient. However, Polkaswap will also offer three distinct PSWAP reward pathways based on the tokenomics of the hub token, XOR. On Polkaswap itself, classic yield farming will incentivize users to provide liquidity in XOR, while market-making rebates will provide extra incentives for large-volume traders. Joining the SORA v2 network will give users another way to earn PSWAP via rewards determined on a token bonding curve.
This last bit may sound complex, and we won’t lie: it is. However, we’re committed to making even complex functions both understandable and accessible through posts like this, proactive community relations (check out our Telegram channel and the SORAmbassador program), and user-friendly interfaces (try the Fearless Wallet, which is custom-made for the Polkadot and Kusama networks and will incorporate Polkaswap features soon).
If you’re as excited as we are about all of this, check out Polkaswap here.