Crypto Valley Live (ID: cryptovalley)

Crypto Valley Live (ID: cryptovalley)

, Author: Marvin Lee, translation: Jeremy, reprinted with authorization by Odaily.

For investors, the property of asset liquidity is crucial, and it is no exception in the decentralized world of finance & investment.

Likewise, liquidity is a key factor in the long-term success of an exchange, helping to form the infrastructure for buying & sharing cryptoassets.

But what exactly is liquidity?

And what about the liquidity situation associated with DeFi, a crypto space that has more than $42 billion locked up so far.

(If you're not sure what lockup means in the context of DeFi, take a look at this).

When we consider that this time last year, according to DeFi Pulse, the TVL (Total Locked Volume) of the DeFi ecosystem was "only" $558 million, which begs the question:

• What were the key factors in the exponential growth from $558 million to over $42 billion?

• Liquidity pools and providers form the backbone of DeFi

let us start.

What is liquidity?

let us start.

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What is liquidity?

Liquidity measures how easily one asset can be converted into another with as little change in asset price as possible.

When assessing liquidity, there are 3 core aspects to consider.

They are: Slippage, Spread and Rate.

——What is slippage?

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

Suppose you decide to buy a coin whose fair market price is $5/coin.

You choose to trade.

However, between the time you initiate the trade and the time it closes, the market price of that asset has changed.

So, you ended up buying these coins for $5.04/coin.

This is slippage.

This may not seem like much, but imagine your order is 10,000 coins.

You will pay an extra $400 for the trade because of the slippage.

Slippage can become an issue when an exchange has a small amount of currency available for purchase. It can also become a problem when markets or assets are highly volatile.

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

In theory, an exchange with high liquidity will have more coins available for purchase and a low level of price volatility for the coins.

If an exchange has low liquidity for a particular asset, and people really want that asset, then people have to decide whether they want to live with (potential) slippage.

Decentralized exchanges often allow people to adjust the level of acceptable slippage.

And due to the increase in the total lock-up volume of DeFi, the competition between decentralized exchanges and centralized exchanges is becoming more and more fierce, because this involves market making with low-level slippage.

——What is the spread?

Spread refers to the difference between the bid and ask price of an asset.

It is different from slippage.

Slippage tells us the price movement after placing an order.

The spread tells us the difference in price preference between buyers and sellers before placing an order.

Wider spreads can mean lower levels of liquidity for an asset or for the exchange as a whole. Centralized exchanges - at least historically - have been favored over decentralized exchanges, often because of better spreads offered.

However, AMMs (or Automated Market Makers) have proven to be reliable solutions — and key infrastructure components — for those interested in using decentralized exchanges in the DeFi ecosystem. AMMs rely on mathematical formulas to price assets.

They are helping to improve the spread issue, among other issues.

——What is speed?

Speed ​​refers to how quickly asset transactions can be processed and confirmed.

Take real estate assets, for example.

If you own a home and decide to sell, how likely are you to sell it for a reasonable price within an hour? Or, if you own Tesla stock, can you trade it for the dollar equivalent within the next 30 minutes?

The speed at which transactions are processed depends on the type of asset, and how the asset is traded.

Transaction confirmation times are a challenge for both Bitcoin (BTC) and Ethereum (ETH) - the majority of the DeFi ecosystem is built on the Ethereum platform - especially since transaction fees will scale with the system. Crowded and fast way up.

However, the block proposal pipeline is an example of a newer protocol layer development where once block validators have obtained two-thirds of the required signatures for a particular block, they can start proposing a new block. In simple terms, this allows for faster transaction confirmation times.

Individuals looking to trade prefer speed - naturally - and don't want to encounter high fees just to go from one asset to another.

Slower processing speed + higher fees = not a good place to liquidate (unless you really need to liquidate)

If the Ethereum platform is heavily congested, speed can become an issue.

Slippage, spread and rate are a whole.

These three core aspects can together help to understand the liquidity status of an asset or an exchange in the encrypted world.

This leads to what is the backbone of DeFi and why there has been such a large increase in total locked positions: liquidity pools & providers.

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How liquidity pools and providers are the backbone of DeFi

Exchanges need market makers.

As mentioned above, aspects such as slippage, spread, and velocity are important considerations, as these three aspects help to understand the liquidity status of a particular asset or exchange.

In DeFi, markets are driven by liquidity pools.

Liquidity pools are composed of liquidity providers.

And these, combined with automated market maker algorithms (AMMs), present a novel solution in DeFi.

It can be said that the automated market maker algorithm acts as a conduit, enabling buyers and sellers to conduct business in a trustless and frictionless manner.

Therefore, liquidity providers can be rewarded for providing the assets needed for market making.

But how does it work?

Essentially, when a token holder makes a deposit to a crypto liquidity pool (assuming the token is acceptable), a new token is automatically generated that represents the depositor's share of the pool.

These are known as Liquidity Provider (LP) tokens, and such tokens often have many potential uses, whether within the native platform or in other decentralized finance applications.

One of the main uses: For depositors, a part of the platform transaction fees can be charged proportionally according to the amount of funds pool owned by the depositor.

While retaining full custody of its encrypted assets.

In this way, not only the assets required for market making are provided in a decentralized manner, but also the fees obtained by the platform are distributed in a decentralized manner.

But there are many more uses.

Since the liquidity provider token (LP token) has multiple uses, the liquidity within DeFi can be multiplied.

This same LP token can be staked and token holders can also earn rewards through this activity.

Let's look at this situation in 4 steps:

Step 1 - Individuals holding ETH provide liquidity to the pool by transferring their ETH into the pool; they are now a liquidity provider.

Step 2 - The provider receives LP tokens (native to the platform) representing ownership of the token along with ETH in the liquidity pool.

Step 3 - The owner "stakes" LP tokens on the native platform.

Step 4 - LP token holders earn a portion of fees by providing liquidity and staking LP tokens.

This is the tokenization of a certain percentage of verified ownership in a liquidity pool. Participants in the pool earn a certain percentage of fees for providing liquidity to a specific platform. This token can be staked for additional rewards.

Meanwhile, liquidity pools themselves - combined with AMMs - are enabling the buying and selling of digital assets.

without the need for middlemen.

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