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The Importance of Liquidity in Decentralized Exchanges

Why Liquidity Matters in Decentralized Crypto Exchanges

Learn what liquidity is, why it's critical to the success of DEXs, and new strategies to improve liquidity.

Decentralized exchanges (DEXs) have become increasingly popular within the crypto community but still account for only 11% of trading volume compared to centralized exchanges (CEXs). While they offer users more privacy and custody of their assets, the liquidity trade-off has been a key sticking point preventing wider adoption.

In this article, we’ll look at what liquidity is, why it’s critical to the success of DEXs, and some new approaches DEXs are taking to improve liquidity.

What is Liquidity?

Liquidity refers to how quickly and easily you can buy or sell an asset without affecting its market price. In highly liquid markets, there are many buyers and sellers, and transactions occur swiftly with minimal price impact. On the other hand, low liquidity indicates fewer market participants and potential difficulties in executing trades without price changes.

The three most significant factors influencing liquidity include:

  • Trading Volume – This factor refers to the total amount of assets traded within a specific timeframe. Higher trading volumes generally indicate more liquidity, suggesting a robust and active market.
  • Market Depth – Market depth refers to the volume of buy and sell orders listed on the exchange at various price levels. A deep order book implies a higher level of liquidity, allowing larger orders to be filled easily without substantial price changes.
  • Bid-Ask Spread – The spread refers to the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask). Narrower bid-ask spreads are typical in liquid markets.

Order books offer the best way to visualize liquidity since you can quickly see the market depth and compute the bid-ask spread.

What is Liquidity?
A conventional stock market order book showing bid and ask orders. Source: OTCMarkets

In the example above, the order book shows the bids and asks for the Grayscale Bitcoin Cash Trust (BCHG) shares. The bid/ask spread is $0.04 ($3.26 – $3.22 = $0.04) or 1.2% of the market price of $3.23 at the time – much higher than more liquid securities like the S&P 500 ETF (SPY) or Apple Inc. (APPL) that is a fraction of a percent.

The order book is also relatively shallow. Someone looking to sell 1,000 shares would drop the price considerably. The first 208 shares would sell for $3.22, the next 200 would sell for $3.21, another 100 would sell for $3.20, and the remainder would sell for $3.15. The final $3.15 sales would be a 2.47% drop from the market price.

Understanding liquidity is crucial for traders and investors. As we’ve seen, if you place a market order to sell in an illiquid market, you might sell an asset at an unexpectedly low price. Low liquidity also makes markets more susceptible to manipulation, such as pump-and-dump schemes, since large trades can easily sway smaller order books.

DEX Liquidity Challenges

Centralized exchanges manage liquidity internally with their own reserves or by working with market makers to ensure sufficient liquidity. As a result, they offer more efficient pricing and greater liquidity than decentralized exchanges that rely on incentivizing individual users and computing prices via complex smart contracts (that increase cost).

Critical challenges for DEXs include:

  • Complexity – DEXs rely on smart contracts to manage liquidity by adjusting incentives. However, poorly designed smart contracts may slow transactions or increase costs, discouraging participation and reducing liquidity.
  • Network Effects – Liquidity begets liquidity. A DEX with a small user base may struggle to attract more users due to low liquidity, creating a vicious cycle. On the other hand, a DEX with high liquidity may experience a virtuous cycle.
  • Fragmentation – Crypto assets spread across various DEXs, creating less liquidity on individual DEXs if the market contracts. By comparison, a CEX could intentionally make a market for any token via their market makers.

That said, the liquidity disadvantage could disappear as DEXs improve. In a 2021 study, Barbon and Ranaldo compared CEX and DEX platforms in terms of market quality and found that although DEX prices are less efficient than CEX prices, their analysis of transaction costs and departures from no-arbitrage conditions suggest that liquidity is similar.

Improving DEX Liquidity

Decentralized exchanges generate liquidity using liquidity pools and automated market makers. While these techniques have become well-established, new innovations are continuously pushing the boundaries to improve price discovery and liquidity.

Liquidity Pools

Many DEXs use liquidity pools, where users, known as liquidity providers (LPs), lock their assets into a smart contract to facilitate trading. To encourage these users, DEXs offer rewards, often in the form of the exchange’s native token, proportional to their contribution to the liquidity pool. For instance, LPs might receive 0.25% of overall trading fees.

As yield farming matures, these liquidity pools could become deeper. Innovations like multi-asset pools and automated yield farming could also simplify the process for LPs. Rather than staking individual assets, they could automatically stake their portfolio as-is to earn a yield, and liquidity pools would automatically rebalance over time.

Market Makers

Automated market makers (AMMs) are algorithms that automatically set prices between crypto assets in a liquidity pool based on a preset formula. Like a traditional market maker, these methods can ensure constant availability of assets for trading at some price. But, offering the best price remains challenging for these smart contract-based protocols.

Dynamic market making (DMM) adds an “amplification factor” based on a pair’s inherent volatility to better compensate LPs for risk. This method adjusts trading fees automatically based on volume and price volatility.

Interoperability

Cross-chain interoperability with other crypto projects and platforms can pool liquidity to benefit every party involved. If one liquidity pool lacks depth, a protocol could swap assets with another liquidity pool to better facilitate a trade.

For example, Deeper is a proposal for a trading volume token that would enable liquidity providers across multiple trading pairs to trade against a common token to share liquidity. Experiments on historical prices show that for a batch consisting of eight trading pairs, Deeper enhances liquidity by over 2.6x to 5.9x.

Governance

Many DEXs employ decentralized governance models, where token holders can propose and vote on changes to the platform. These changes can directly impact liquidity. Responsive governance structures ensure the platform evolves according to the user needs, which include strategies to maximize liquidity using new and innovative approaches.

The Bottom Line

Liquidity plays a crucial role in every financial market. Without liquidity, it’s difficult for buyers and sellers to transact at reliable prices, and markets become less vibrant. While market makers ensure sufficient liquidity in centralized exchanges, DEXs attempt to democratize the process through smart contracts, enabling decentralized liquidity.

Of course, liquidity isn’t the only factor influencing decentralized exchanges. Price discovery, ease of use, and other factors are also barriers preventing more widespread adoption of DEXs. But like liquidity improvements, innovations are addressing these issues to help increase adoption.

If you trade crypto assets, ZenLedger can help you organize everything for tax time. Our platform aggregates transactions across wallets and exchanges (including DEXs), computes your capital gains and losses, and generates the paperwork you need to file.

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The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.

Justin Kuepper

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