Liquidity Makes Trading Possible, Efficient Liquidity Makes Trading Easy

22-08-2022

AXO

The Principles of Liquidity

Traditionally, liquidity has been thought of as the ability to exchange an asset without impacting its price. However, to understand why liquidity moves from one market to another, it is helpful to expand this definition to think of liquidity as: how quickly and easily a given asset can be turned into the desired outcome. In most instances, a market participants’ desired outcome would be the easy exchange of X for Y at a specific price point, at a specific point in time (ideally instantly) — and they will take their assets wherever they can get their desired outcome.

Let’s look at market value (the current price at which an asset can be bought or sold) to learn why a market participant’s desired outcome is not always possible. Market value is determined by the intersection of the buy and sell pressure created by market participants trading and placing buy and sell orders (see graphic 1). All open and unfulfilled buy and sell orders in a market can be thought of as market participants’ requests for their desired outcome.

Graphic 1: Healthy Market Liquidity Model

In a sense, there is always liquidity if a market participant is willing to compromise on their desired outcome. Both buyers and sellers will ‘find’ more liquidity the further away they move from the market value of an asset (See graphic 1). However, market participants will always look for where they can easily and quickly execute their entire trade at a price point closest to the market value without that market value moving — to do so requires ‘deep’ liquidity.

Any market for an asset that can reliably absorb a high volume of near-instant exchanges with minimal or no price impact has deep liquidity (the asset is highly liquid). If an asset is illiquid, there is insufficient liquidity to support trading volume at a stable price, and trades will delay, fill only part of an order, not execute, or significantly move the market value.

How assets become available for exchange differs slightly from traditional finance (TradFi) markets to crypto markets, but these principles of liquidity remain the same. If market participants cannot get their desired outcome quickly and easily, they will move their assets somewhere they can.

Why liquidity is important

Bitcoin (BTC) once had no fiat value and was supported by a very small community. The only way to receive BTC was by mining (running a network node) or negotiating with others on obscure online forums to trade in single transactions. Once the first crypto CEXs came online in 2010, they created liquidity for BTC, allowing different liquidity providers (asset holders) to meet at a single point. The CEXs created bid and sell exposure to a wider variety of market participants in fiat currencies and other crypto tokens. People no longer needed to own and operate mining equipment to acquire BTC, and those who did could sell their BTC to support their mining operations.

Today BTC is available in many different markets. The market value has risen from 0.09USD to an all-time high of 68,789.63USD (at the time of writing), and there is a healthy community of millions of BTC holders worldwide.

The BTC example highlights an important lesson about liquidity, an asset’s value and support can only grow as much as there is liquidity for it to do so. The same is true for the DeFi ecosystem as a whole.

Even a market with two participants needs liquidity to function. Both parties need to bring liquidity for the asset the other party wants to exchange. For example, if one market participant wants to exchange 100ADA for 100USD with another willing participant, one must provide 100ADA and the other 100USD to fulfill the liquidity of the trade.

Each market participant has their own ‘desired outcome,’ so a trade is not always so simple. With fewer market participants, the bid-offer spread (the difference between the current maximum buyer’s and seller’s price) is likely to increase as there is less of a chance that two desired outcomes will match (see graphic 1). In the two-participant market example, suppose one party wants to trade 100 ADA for 110USD, but the other wants to trade 100USD for 100ADA. There is a discrepancy in the desired outcomes of 10USD/ADA — one or both parties will have to compromise on their desired outcome (change their asking price) for enough liquidity to be available for the trade.

With many market participants, the bid-offer spread should reduce (tighten) as more liquidity is brought to the market, and the chance of two ‘desired outcomes’ matching increases. The additional liquidity and subsequent tighter bid-offer spread mean market participants do not have to go far from the market value to buy and sell, allowing for greater price discovery and stabilizing an asset’s market value.

Deeper liquidity also increases the ease and speed of transactions as each bid has the liquidity to be matched. When the price is stable, and exchanges are both quick and easy, risks associated with the market are reduced. These factors make a market more attractive, create more market participation, increase liquidity further, and subsequently attract more market participants in a positive feedback loop.

The DeFi Problem

When it comes to liquidity, DeFi doesn’t have a volume problem — as of the time of writing, there is over 250 billion USD of liquidity currently in the ecosystem — it has a utility problem.

In TradFi or on a CEX there are, broadly speaking, three types of market participants who bring liquidity to the market.

Market participant 1: is looking to buy and hold an asset with the expectation that the value of their purchased asset will increase over time, and they can sell for a profit.

Market participant 2: is looking to profit from the constant price movement of an asset. They use financial tools and take advantage of fundamental and quantitative analysis and market research to determine the best time to buy and sell.

Market participant 3: is not interested in an asset’s long-term price movement but the trading volume. These market participants are known as market makers (sometimes: liquidity providers). They hold enormous amounts of liquidity (assets and cash), which they supply to the market in exchange for a portion of an exchange’s trading fees. A market maker’s liquidity ensures all of the benefits mentioned above: fast, reliable, stable, and easy to use markets — they are essential to the smooth running of the largest exchanges in the world. Even if there is no match between other market participants, the market maker will match the buy and sell orders that are close to market value to keep the market moving and the bid-order spread tight.

DeFi is different.

DEXs are not owned and operated by an entity, they are decentralized. Decentralization has many advantages, including eliminating human corruption and reducing counterparty risk. In DeFi, the protocol will always do what it is programmed to do because it cannot do anything else — this is verifiable by its open-source code.

Because DEXs are decentralized, they don’t have market makers (marker participant 3) in the traditional sense. The task of the market maker on a DEX is divided between many individuals all pooling their assets together in a liquidity pool (LP) and an algorithm built into the DEX protocol called an Automated Market Maker (AMM) that distributes liquidity. An AMM provides liquidity for each side of a buy and sell order, ensuring a market participant’s order gets filled without needing another market participant to match their desired outcome.

While current AMMs might keep trading constant, they are an incredibly inefficient use of liquidity.

Most AMM protocols are constant-function market makers (CFMM), which treat every price point as equal even though trading typically occurs in a narrow window of price points (see graphic 1 for a healthy market scenario).

So, how does a DEX keep trading constant? How does a market participant’s order get filled when no other market participant has a matching desired outcome?

Graphic 2: CFMM Market Liquidity Model

A CFMM using the most simple (and popular) LP model formula (x ∗ y = constant) doesn’t just provide liquidity around the market value; it provides an equal amount of liquidity at price points ranging from 0 to infinity — minimizing liquidity at every price point (see graphic 2). This stretching of liquidity means that even if there is a lot of liquidity locked into a protocol, a single trade can significantly impact price as the protocol searches for liquidity (moves through the available liquidity per unit of price) to fill the order.

‘Slippage’ is a phenomenon where a market participant exchanges their assets at a loss compared to the original market value due to insufficient liquidity at the initial price point (desired outcome). Slippage causes high price volatility. With A CFMM model, an LP needs enormous liquidity to minimize even the smallest slippage.

Inefficient use of liquidity, in the extreme, is akin to having very little liquidity even when an LP holds a large number of assets. The effect is unreliable and slow markets, with inaccurate and highly volatile prices — markets most would want to avoid or move on from if given a chance.

To stave off the exodus from DEXs to CEXs, DeFi needs to create comparable or better experiences in the ecosystem, and with it will come innovations and growth.

Moving Forward in DeFi

DeFi has already demonstrated enormous interest in a decentralized future — hundreds of billions of USD worth of interest. The next step forward for DeFi is more sophisticated liquidity modeling and trading options.

Liquidity needs to be concentrated within a realistic window of price points and be able to move as needed when the market value goes up or down — just as it would on a large TradFi exchange or CEX.

Concentrating liquidity means that DEXs can provide constant and easy trading at price points close to market value without spreading liquidity across an infinite spectrum of price possibilities.

UniSwap v3 has taken the first significant step toward concentrated liquidity on DEXs. LPs for trading pairs on UniSwap V3 can concentrate liquidity into smaller intervals than (0,∞) called ‘positions’ which provides deep liquidity in a set window of price points. However, the liquidity in a position does not follow asset price movements. If an asset’s price moves outside of the bounds set by one position, a new position needs to be created by the LP to give liquidity for the new market value. Although many positions can be created at once to anticipate price movement, all the liquidity in ‘non-active’ positions remains unutilized.

To fully utilize the potential of liquidity, DEX protocols need to allow liquidity to both concentrate around a narrow price point window and follow (not anticipate) the market value as it moves up or down. Keeping liquidity agile means almost no liquidity is wasted anticipating price points or worse, spent supporting unrealistic price points.

Freeing up liquidity from unrealistic price points for any single trading pair on a DEX also allows it to be spent supporting new trading pairs, expanding the entire DeFi ecosystem. The end result is deeper liquidity at prices people are willing to trade and accelerated market growth.

In addition to better LP modeling, DEXs need more trading options. Currently, most DEXs do not offer any sophisticated trading options beyond order books or a simple market order — which, as we described above, is executed on AMMs with poor liquidity across price points that can cause significant slippage and disruptions in trading.

Limit orders, stop losses, options, futures, the ability to short assets, and other financial instruments can all create cross-market liquidity — effectively adding more liquidity to the market without adding any additional underlying assets. The creation of new markets via financial instruments then presents arbitrage opportunities which, combined with the added precision of better trading tools, lead to better price discovery, pushing assets closer to their ‘true market value’ and stabilizing the market.

Sophisticated trading options also attract sophisticated traders who would not usually trade without tools that meet their risk control requirements and trading specializations. Sound and sophisticated trading options can open DeFi markets to professional crypto-traders, large crypto investment firms, VC funds, family offices managing fortunes, and many more institutions and individuals who will bring enormous amounts of liquidity with them.

CEXs like Binance offer sophisticated trading options — albeit with sometimes questionable reliability — and this in part explains the liquidity discrepancy between CEXs and DEXs. More trading options in DeFi is an opportunity to court more liquidity from trading professionals and institutions while simultaneously creating new markets that can supercharge liquidity in DeFi. If the added liquidity is utilized correctly, it can help position DeFi and DEXs as true challengers to centralized finance.

The good news is that the DeFi community has the infrastructure and mathematical models to achieve realistic liquidity modeling and advanced trading tools with the next generation of DEXs. In the white paper, you can read Axo’s solution to realistic liquidity modeling and novel trading options for DEXs.

Closing Thoughts

We cannot be satisfied with the large amounts of liquidity pouring into DeFi — we need to utilize it. There is no reason to believe that the liquidity will stay in DeFi if it cannot be traded quickly, easily, and reliably. Crypto projects will continue to be traded primarily on CEXs until the trading experience on DEXs is at least comparable. The DeFi revolution doesn’t just depend on liquidity, it depends on liquidity at a price point people want to trade.