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What Is Liquidity and How Does It Drive the DeFi Sector?

Written by: Coinpedia

July 14, 2022

If you are considering investing in crypto, you have probably stumbled upon the term liquidity at one point. Though it may seem like something related to the DeFi sector only, liquidity has been around for much longer. 

So, what is it, how does it work, and how does it affect the DeFi space? Let’s explore.

What Is Liquidity?

Liquidity refers to how quickly an asset can be converted into cash. To help you understand this concept better, let’s take a look at an example.

Imagine having a vintage car — a 1958 Pontiac Bonneville, for example. Would you be able to sell it at the real market price quickly? Even if you’re a vintage car dealer with a huge community behind you, you will probably have to wait for some time before someone interested comes along and is willing to pay the price. In other words, you might have to adjust the cost of the car a bit to find a buyer. Therefore, it’s safe to say that the Pontiac wasn’t completely liquid.

So, what’s the most liquid asset? It’s simple: cash. If you live in the US and have American dollars, you can exchange them for whatever you want, as the dollar is the main means of exchange in the country. What’s the most illiquid asset? Well, it’s tough to say, but many professionals agree that real estate is definitely very illiquid.

Liquidity in the DeFi Space

With the introduction of cryptocurrencies, transactions around the world became fast and secure, paving the way for many decentralized finance projects. Digital assets, like their physical counterparts, are also located somewhere on the scale between total liquidity and illiquidity. 

For example, Bitcoin is currently considered a very liquid asset, as you can quickly convert it for another cryptocurrency or even fiat money. Simply put, tens of thousands of people are actively trading Bitcoin around the globe. Of course, it’s not just Bitcoin, as you need to find a popular cryptocurrency exchange that has enough traders willing to trade digital gold. 

Moreover, liquidity is affected by the trading pair that you concentrate on. For instance, if you are trying to buy some ETH for BTC using the most popular crypto exchange in the world, the chances are you’ll complete the transaction quickly.

However, selling Bitcoin for rare and unpopular crypto that isn’t traded often could be a challenge. So, what should you do if you want to buy or sell an illiquid cryptocurrency? Should you just wait while the prices of cryptos fluctuate on a daily basis, thus risking your trading strategy? 

Actually, the brilliant minds working in the industry have managed to solve that issue as well by creating so-called liquidity pools.

Liquidity Pools

Nowadays, online exchanges allow their users not only to trade funds but also to deposit them. Imagine, for example, a BTC/EOS pair. Even though BTC might be popular, the currently 50th largest coin by market cap, EOS, might struggle with liquidity on certain exchanges. But if you own both of these coins, you can deposit them in a pool, creating superficial liquidity. In other words, you create a supply of both tokens to meet the demand for trading and make the coins liquid.

Blueshift is one of the exchanges that feature liquidity pools. On top of that, it’s also an Automated Market Maker (AMM) exchange, which features an algorithm that automatically creates trading markets based on liquidity pools. It technically builds and sustains liquidity pools automatically — however, users will still have to deposit their funds into the pool to get things started.

How to Profit from Liquidity Pools

Suppose you decide to stake your cryptocurrencies in a liquidity pool. You may be wondering — why would I do that? Of course, those who deposit crypto don’t do it for free — they get an incentive for doing so. Whenever traders make a trade, they have to pay fees for that, and a portion of these fees is distributed to liquidity providers — the people who decide to stake their funds in a liquidity pool. Therefore, by staking your crypto, you’ll make a passive income, and the more you stake, the larger the portion of the fee you’ll receive.

In a way, liquidity pools helped create a DeFi mechanism that makes every party happy. Of course, the profit you’ll receive depends on the overall prominence of the exchange where you’ve staked your funds, the popularity of the crypto pair you deposited, and the general state of affairs on the crypto market.

Final Thoughts

Liquidity pools are just one of the things in the DeFi space that drive it forward. Some of the most brilliant people in the world are currently developing multiple other protocols that use liquidity, with a goal to improve DeFi further and make decentralized finance even more appealing when compared to its traditional counterpart.

It should be interesting to observe how the current liquidity pools will evolve and if they will be sustainable in the long run.

Coinpedia

Crypto Journalist and Editor of guest articles in CoinPedia. I am also handling Outreach & Partnerships Manager. Contact me: info@coinpedia.org

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