What is Liquidity, and why is it so important?

This article explains liquidity, automated market makers, and why they're a vital part of the DeFi ecosystem.

Divi Project

December 02, 2022 · 3 min read

Liquidity

What is Liquidity

When trading, the goal of every buyer and seller is to purchase and sell an asset at the best possible price. The outcome of these trades is determined by the amount of market liquidity, which refers to how easily an asset can be traded without affecting the market price.


The more often buyers and sellers actively place orders for an asset, the more liquid the asset is. This helps to maintain the value of the assets being exchanged. In contrast, markets with low liquidity likely have little to no trading activity and are more susceptible to manipulation and severe volatility. A single large purchase or sell transaction could cause sharp price movements in an illiquid market.


High liquidity, therefore, promotes market stability and produces more equitable prices for both buyers and sellers. The existence of more active market participants also inherently facilitates speedier transactions. We can look forward to these benefits when the Divi DeFi platform goes live.

Liquidity Graphic

Liquidity

Trading markets must have adequate liquidity to function. However, centralized and decentralized exchanges provide liquidity in very different ways.

Liquidity on Centralized Exchanges 


A centralized exchange provides an order book mechanism to quickly and smoothly match buyers and sellers. They serve as the middleman between traders. As we have seen consistently, third-party custodians should not be trusted with your funds.


How trading works on a centralized exchange:

  • Trader A places an order to buy 1000 $DIVI at $0.02 each. (“Bid”)

  • Trader B places an order to sell 1000 $DIVI at $0.02 each. (“Ask”)

  • The exchange will match Trader A with Trader B, who is prepared to sell at Trader A's preferred price. 


For trades to occur, buyers and sellers must agree on a price, but often there is a difference between the highest bid and the lowest ask (“Spread”). What if no one is prepared to place their orders at a reasonable price? What if there is a low supply and there aren't enough coins to go around? This is where market makers enter the picture…


Market makers, in essence, are businesses or entities that support trading by constantly being available to buy or sell a specific asset. They enable consumers to always be able to trade without waiting for another counterparty and profit from the difference in the bid-ask spread. 

Market Making

MarketMakers

Liquidity on Decentralized Exchanges

Contrary to the CEX model, DEXs facilitate trades by connecting users directly without the involvement of a centralized order book. The core technology that enables this type of exchange is called an automated market maker (AMM), which operates autonomously, eliminating the need for centralized exchanges and traditional market-making techniques. 


AMMs determine the price and availability of digital assets based on liquidity created by users depositing funds into smart contracts. Customers trading on DEXs are not trading against counterparties but rather against the pooled liquidity inside smart contracts (“liquidity pool”). Without this liquidity, AMMs would be unable to match buyers and sellers.


Since traditional market makers are not being utilized, users (“liquidity providers”) are actually incentivized to provide liquidity to these trading pairs and earn a share of the generated trading fees.  


When adding tokens to DeFi liquidity pools, liquidity providers must supply both tokens that make up a trading pair and receive liquidity provider tokens (“LP Tokens”) in return. These LP tokens are a representation of the contribution to the liquidity pool. More on LP tokens and the resulting yield will be discussed in more detail in our next article. 


Example of providing liquidity to a DIVI/ETH pool:

  • Liquidity provider adds $100 USD equivalent of DIVI(ERC-20) to the pool. 

  • Liquidity provider also adds $100 USD equivalent of ETH to the pool.

  • Liquidity provider receives a proportionate amount of LP tokens, entitling them to a part of the pool's transaction fees. 

LP Tokens

Liquidity Pools

In summary, DeFi liquidity offers many advantages over traditional centralized services. Liquidity pools enable users to trade peer-to-peer, eliminate middlemen and centralized entities, and incentivize liquidity provision. With the launch of the Divi DeFi platform, users will have more ways to earn rewards by putting their coins to work for them. 

Up next: an in-depth look at yield farming and how to be prepared.

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Divi Project

December 02, 2022 · 3 min read

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