Hey Riders, today we are going to discuss the very important issue of liquidity and how it affects various outcomes in swap and liquidity provision. Let’s start by understanding what liquidity is, why it’s important, and what to consider in terms of slippage, price impact, and temporary losses.
In the cryptocurrency world, “liquidity” refers to how easily a digital currency or token can be converted into another digital asset or cash without affecting the price, and vice versa. Because liquidity is a measure of how much external demand and supply there is for an asset, a market that is deep and has a lot of liquidity is a healthy market. All else being equal, the more liquid a cryptocurrency or digital asset is, the less volatile and more stable it should be.
Total Value Locked (TVL) refers to the total value of crypto assets placed in a decentralized finance (DeFi) system or in DeFi protocols in general. It has become a critical statistic for assessing interest in this specific segment of the cryptocurrency business.
TVL covers all coins placed in all features of DeFi protocols including:
Staking, Lending and Liquidity Pools.
Importantly, it does not represent the projected rate of return for these deposits. It relates exclusively to the current value of the deposits.
A project’s TVL changes as clients make new deposits or remove their assets. It is constantly changing according to the changing dollar value of all cryptocurrency assets. Some or maybe all of the deposits in a DeFi system can be denominated in its native token. As the protocol’s native token increases in value, its TVL also increases in value.
TVL can be used by investors to determine if a DeFi project’s native token is reasonably priced. The token’s market cap can be high or low relative to the project’s TVL. The more intense the connection, the more the token can look overpriced or undervalued.
Others argue that since most crypto projects are open source, they live and die on the basis of community acceptance and the network effects created by widespread usage. Any honest metric should consider the value generated for users, not just the locked value. They also highlight TVL as an outdated and AMM-specific measure, saying we need measures that assess inherent value. Only by evaluating the intrinsic value can we determine how much the project is really worth. The most important thing to look at is the value a protocol offers and how well it does it. Everything else is less important and can be manipulated. They also say this isn’t to mean we should never investigate financial measures, but the map doesn’t always correspond to the region.
Many decentralized exchanges (DEX), like WingRiders, rely on liquidity pools. To form a market, users known as Liquidity Providers (LP) combine the equal values of two tokens into a pool. In return for putting their money into the pool, they receive trading fees on trades that occur in their pool based on how much liquidity they have in the pool overall. So, a liquidity pool is a collection of tokens that have been locked into a smart contract. Liquidity pools are used to support decentralized trading, lending, and a variety of other Decentralized Finance (DeFi) activities.
A liquidity pool, as mentioned earlier, is a collection of tokens placed into a smart contract by liquidity providers. When you execute a trade on an AMM, you don’t have a typical counterparty. Instead, you trade against the liquidity in the liquidity pool. There does not have to be a seller at this point for the buyer to buy; all that is required is sufficient liquidity in the pool.
When you buy a token on WingRiders, there is no typical seller on the opposite side. Instead, the algorithm that determines what happens in the pool manages your activity. In addition, this algorithm determines the price depending on transactions that take place in the pool.
So it’s clear that high liquidity in a pool is important, but what happens when a pool has low liquidity?
Low liquidity in a pool can make a big difference between the projected cost of a token transaction and the actual cost. Because so few tokens are locked into pools, token changes in a pool, whether as a result of a swap or other activity, result in higher imbalances. Traders won’t experience much slippage if the pool is extremely liquid.
One of the risks of trading in a low liquidity pool is “slip”. When you trade a DEX, you are essentially depositing one token into the pool and withdrawing another. The higher the value of your trade or the total trading volume within the pool, the more the liquidity in the pool becomes uneven and causes prices to slide. The less liquid the pool, the more likely slippage will affect your business. Nobody likes getting fewer tokens than expected. You control the slip on the WingRiders DEX. Simply access the “Transaction Settings” by clicking on the “Settings” cog in the top right corner of the exchange window where you can access the Transaction Settings. You will see the different options available.
WingRiders DEX: Setting the slip tolerance
The “Slippage Tolerance” defines how large a change in exchange rate you want to tolerate when creating your swap request. This is important because each request before yours slightly changes the exchange rate between the tokens. In the first row there are some default slip tolerance values, and in the second row you can set your own. If you set a very small tolerance, there’s a chance your request won’t be honored, and if you set a high percentage, the exchange rate could move significantly.
The second issue to watch out for when trading liquidity pools is the price implications. The impact of a user’s individual trade on the market price of an underlying asset pair is referred to as “Price Impact”. It is proportional to the amount of liquidity in the pool. The impact on price can be particularly severe in illiquid markets or pairs, causing a trader to lose a significant portion of their capital. The price impact can also be seen very clearly when doing a swap on the DEX. This is displayed just below the SWAP interface when you click the arrow next to Total Charges. In the image below you can see that the price impact on this trade is 0.769%.
WingRiders DEX: Swap price impact indicator
Finally, it is important to understand what impermanent loss is. Although this concept is not directly related to liquidity, one should still be aware when providing liquidity. The drop that occurs when the price of the assets you deposit changes between deposit and withdrawal is known as a “Ephemeral Loss.” If the difference is larger, the loss is larger; if it is smaller, the loss is smaller. The loss arises from placing two cryptocurrencies in a liquidity pool and later withdrawing them with a difference in value that is less than the difference in value you would have received if you had kept the coins in your wallet. The temporary loss is not felt until it is removed from the liquidity pool; hence it is called impermanent.
After reading this you should have a better idea of what liquidity is and what to look out for when working with liquidity pools.
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