In Web3 and decentralized finance, liquidity refers to the ability of an asset to be quickly and conveniently bought or sold without significantly affecting its market price.
You can think of it as the market's 'depth' and 'activity level'. The higher the liquidity, the smoother the trading experience and the more stable the prices.
1. A simple analogy: the old book market
To better understand, let's use an old book market as an analogy:
1. Low liquidity market (poor liquidity)
1.1 You have a rare edition book that you want to sell. There are only one or two buyers in the market, and their offers are very low.
1.2 When you want to buy this book, you also have to wait a long time for someone to sell it, and the seller will demand a high price.
1.3 Result: Difficult transactions, large bid-ask spreads, your trading activities themselves can severely impact prices.
2. High liquidity market (good liquidity)
2.1 There is a huge old book trading center with thousands of buyers and sellers.
2.2 If you want to sell a book, you can immediately sell it at the market fair price.
2.3 If you want to buy a book, you can also immediately buy it at the market fair price.
2.4 Result: Convenient trading, small bid-ask spreads, your single transaction has a negligible impact on the overall price.
In Web3, decentralized exchanges (DEX) are like this huge old book trading center, and liquidity providers (LPs) are those who deposit their books (assets) into the market, making trading possible.
2. Key scenarios and components of liquidity in Web3
1. Decentralized exchanges (DEX) and automated market makers (AMM)
This is the most core application scenario of liquidity.
Traditional model: In centralized exchanges (such as Binance, Coinbase), liquidity is provided by order books, i.e., the list of orders placed by buyers and sellers.
Web3 model: In DEXs (such as Uniswap, PancakeSwap), the automated market maker (AMM) model is adopted. It no longer relies on order books but instead relies on a liquidity funds pool.
2. Liquidity funds pool:
This is a smart contract that holds two or more pairs of crypto assets (e.g., ETH/USDC).
Liquidity providers (LPs) deposit these two types of assets into the pool in proportion.
Traders directly trade with this liquidity pool, rather than trading with specific counterparties.
Example: In the Uniswap ETH/USDC pool, LPs deposit both ETH and USDC simultaneously. When you want to buy ETH with USDC, you deposit USDC into the pool and then withdraw the equivalent amount of ETH from the pool (calculated according to the AMM's algorithm). This process does not require waiting for someone to sell ETH.
3. Liquidity providers (LPs) and incentives
Why are people willing to lock their assets in the funds pool?
3.1 Trading fees: Each transaction in the pool incurs a certain percentage of fees (e.g., 0.3%), which are distributed proportionally to all LPs. This is their main source of passive income.
3.2 Liquidity mining: Many DeFi projects incentivize people to provide liquidity by rewarding them with governance tokens of the project. This is known as 'liquidity mining' or 'yield farming.'
4. The importance of liquidity
4.1 Reducing slippage: The higher the liquidity, the smaller the impact of large trades on prices, allowing traders to execute trades closer to expected prices.
4.2 Price discovery: High liquidity markets can reflect the true market price of assets more accurately and quickly.
4.3 Protocol health: The survival of a DeFi protocol (such as a lending protocol or derivative protocol) highly depends on its liquidity. Without liquidity, the protocol cannot operate.
4.4 Capital efficiency: Liquidity allows assets to be utilized more effectively, rather than sitting idle in wallets.
3. Beyond DEX: Other forms of Web3 liquidity
Liquidity exists not only in trading but also in other DeFi areas:
1. Lending protocols (such as Aave, Compound):
Here, liquidity refers to the 'total amount of assets available for borrowing.'
Depositors provide assets to the funds pool, thereby creating liquidity; borrowers can borrow assets from the pool.
2. NFT market:
The liquidity of NFTs is often poor because each NFT is unique.
However, emerging models such as NFT fragmentation (dividing an expensive NFT into many ERC-20 tokens) and NFT liquidity pools (such as Blur's Blend) are trying to inject liquidity into the NFT market.
4. Risks and challenges
Providing liquidity is not without risks:
1. Impermanent loss: This is the biggest risk. When the price ratio of the two assets in the pool changes drastically, LPs may suffer more value loss than simply holding the assets.
2. Smart contract risk: The funds pool is a smart contract and may have vulnerabilities that can be exploited by hackers.
3. Collateral risk: In lending protocols, if the value of the collateral plummets, it may be liquidated.
5. Key points
In Web3, liquidity is the lifeblood that drives the entire decentralized finance world. It incentivizes users (liquidity providers) to deposit their assets into decentralized pools, ensuring smooth transactions, price stability, and the normal functioning of various financial applications (trading, lending, derivatives, etc.). Without liquidity, Web3 would be just an empty shell.
