Liquidity Explained

If you’re wondering how to provide liquidity in a cryptocurrency exchange, you’re in luck! This post is a complete guide! But one thing at a time. First, you need some fundamental knowledge of liquidity itself. Let’s dig right into it.

Liquidity is broadly defined as the ability to sell assets with the smallest price movements possible. Why is the indicator so relevant? Let’s walk through an example. Imagine you want to buy 1,000 coins for a buck each. You place an order, and bang! The price has risen to $1.20. As a result, you have lost $200. Why? Because the digital currency exchange (DCE) does not have enough coins for you to buy, resulting in a shortage. You will have to pay 1–10% more than expected. To simplify a complex economic phenomenon, we can say that the platform has a lack of liquidity. Hence, you have a lack of willingness to deal with it.

Low liquidity usually goes hand in hand with high price volatility. The higher liquidity, the lower price fluctuations. Currently, the most liquid asset is cash. The market easily absorbs a $10 million transaction. There will be no fluctuations in the value of the dollar. You know the cost of such an operation and the price of the currency in advance. But if the same operation is performed with Bitcoin or any other digital coin, the impact on the asset’s value will be much more significant.

Exchanges are very interested in high liquidity. It brings profits and new customers, who, in turn, bring additional liquidity. The more users the platform has, the more funds it rotates, and the easier it is to conduct operations without significant exchange rate fluctuations. It follows that high liquidity is beneficial for both the DCE’s management and ordinary users.

Remember, most liquid cryptocurrency pairs are a very effective way to achieve successful results and new investors. With that said, let’s aim to answer this simple question: how can we deal with the liquidity problem? You can solve it on your own, of course, but you have to expend great efforts and resources. There will be no time to develop the exchange itself. That’s why we strongly recommend checking out our tips.

Market Makers

Market-making is probably one of the least talked about facets of crypto. Everyone loves to discuss which coin will prevail, decentralized vs. centralized exchanges, and regulations. But there is far less chatter on how crypto trading is actually done. To paraphrase a famous quote, you don’t want to see how the sausage (or market) is made. Let’s dissolve some myths and misconceptions about the subject.

Market-making in the crypto space: how is it different from other financial industries? A lot of people who that market makers can generate trading volumes. Some even expect them to support prices. Sorry to destroy your worldview, but market makers can’t guarantee volume. Their job is to create the necessary conditions for people to transact in the most efficient way possible.

New exchanges are launched every day. The teams spend so much time and energy on new features, user-friendly interfaces, and crazy things that allow you to trade crypto. Once they are done, they realize that they have neither users nor liquidity. That is where a market maker (MM) comes into play.

MMs are financial institutions that conclude a special agreement with the exchange and agree to fulfill certain duties. They are large organizations that act as an intermediary between the buyer and seller, and they receive a portion of the profit from the spread/commission or other benefits.

Why do we need MMs? They are important for sustaining the exchange structure and ensuring smooth order processing in the market. They add liquidity and play a special role in the online space, where many tokens lack popularity. In the crypto community, they provide the necessary trading volume, helping investors buy not the most liquid but the most promising assets, protecting the market from manipulation at the same time.

MMs’ main task is to collect the best offers and bring them together. As a result, the transaction is carried out. All open buy and sell orders are placed in the order book. Every trader can view this information. If the depth of the market reaches a satisfactory level, such orders are executed without significant price hikes.

MMs cannot directly influence the cryptocurrency exchange rate, but they may do so indirectly. Their work is technically complex but brings real value to the market and exchanges.

One of the biggest problems for liquidity providers is that some online platforms have very low fees. At the same time, exchanges are well aware of the importance of increasing liquidity and can offer special programs to attract MMS.

Yield Farming

A veritable gold rush is going on in the DeFi space—a rush that has seen some early participants earning lucrative returns on their crypto. These people are not miners, founders, investors, or traders. They are farmers—yield farmers, to be exact. They are people who have found the most lucrative lending and borrowing opportunities around. Some of them have been able to generate more than a 100% yield. The question is, though, what is yield farming really all about?

For starters, don’t think of it like picking tomatoes or going out and harvesting some corn. Rather, it’s a pretty broad term that refers to chasing yield in the DeFi space, allocating crypto to lending, borrowing, and liquidity pools opportunities, and using interoperable protocols to enhance that yield. As bizarre as it sounds, it’s very simple. Yield farming about finding and providing liquidity to receive a yield, and that might come in various forms: interest, marketing-making fees, or incentives or rewards from protocols. These protocols are like a chicken and egg problem. They need liquidity so that they can get users, and they need users so they can get liquidity.

It would be irresponsible to assume that there are no risks involved in yield farming. You cannot generate high returns without accepting additional risks. One of the biggest risks comes from smart contract runner abilities. Hackers and other market participants study these smart contracts intently. If they spot an opportunity to attack a pool or manipulate a price, they’ll jump at it. Moreover, given the interoperability between many of these protocols, they can use one tool against another in a way that no one has predicted. This scenario has happened on quite a few occasions, such as the flash loan attack that took advantage of BZx, Fulcrum, and a few other protocols this year. The long and the short of it is that the attacker took out large flash loans with no capital outlay. He was able to use these funds to manipulate a price Oracle and artificially impact reference prices on smart contracts. Another example is an attack on one of the Balancer pools. This attack was quite sophisticated and, again, used flash loans to take out a considerable position of WETH to trade against STA token. We should not forget about the March MakerDAO vault liquidations. This event occurred when Ethereum had a flash crash that liquidated millions that were stored in these vaults as collateral. So, yeah, there are risks—risks that cannot be ignored.

Liquidity Mining

We want to clear up a little bit of confusion first. You might think that liquidity mining is something crazy or really hard to understand, but the basic concept is a no-brainer. All it means is being rewarded, just like with regular mining. In this case, you get rewarded for providing liquidity. What gets complex is the methods people use.

Liquidity pools are pools of tokens that are used to facilitate an exchange between two tokens. The user can provide their tokens to the protocol so that other people can swap between two different coins. A great many platforms, including Ren, Synthetics, and Curve, offer token incentives to provide liquidity to these pools.

The idea of a liquidity pool is quite simple, but it changes the world of trading and DCE significantly. It allows you to abandon the order book and MMs’ services, distributing the income from trading activity to all pool participants.

Of course, new financial instruments come with new risks. In addition to the standard DeFi risks (smart contract risks, system risks, and admin key risks), there are also the risks of impermanent loss and liquidity pool hacks.

Final Words

If cryptocurrency were a ship on the ocean of finance and technology, liquidity would be the wind and the sails. It’s not immediately visible, but it’s utterly vital for the propulsion of crypto trading into the future. Better liquidity is the key to the institutional adoption of crypto, the end of wash trading on digital currency exchanges, and the success of any digital coin. That’s why it’s such a big deal.

In addition to the tactics mentioned above, there are some others as well. Our guide is not personal advice. What you do is up to you. Please gamble responsibly because that’s exactly what crypto is right now.