What Is Liquidity And How Does It Impact DeFi?

The liquidity of an asset represents the ease with which an investor can convert their assets into cash. That said, the liquidity of DeFi is of utmost importance since the main aim of a trader is to make profits as fast as possible.

What Are Liquidity Pools in DeFi?

A liquidity Pool is an automated market maker that provides liquidity in DeFi to control very high price swings. A user known as a liquidity provider (LP) adds an equal value of two tokens in a pool to create a market and earn transaction fees for these services. Anyone can be an LP in DeFi, and automated market makers like Uniswap are now making the work much more manageable.

What is Liquidity Mining?

In liquidity mining, holders supply their stashes into the liquidity pools in exchange for rewards in the form of tokens and fees.

Types of Liquidity

There are two primary forms of liquidity: market liquidity and accounting liquidity.

Market Liquidity

Market Liquidity refers to how quickly an asset can be converted into physical cash. In effect, it describes how marketable the asset is by showing how it can sell at stable and transparent prices. It is an essential type of liquidity in the crypto market since the investor needs to take advantage of the price fluctuations.

Accounting Liquidity

Accounting liquidity describes the ability of an individual to meet their economic obligations.

How to Measure the Liquidity of Assets

Organizations use liquidity ratios to measure their financial health. There are three crucial types of liquidity ratios that most companies use.

Current Ratio

This ratio calculates the organization’s current assets against its current liabilities. Its main aim is to determine if the organization can settle all its short-term debts from the sale of assets.

Current Ratio = Current assets / current liabilities

Quick Ratio

Quick Ratio is similar to Current Ratio, but they differ in that quick ratio only uses accounts receivable, bond/socks, and cash as assets.

Current Assets = Current liquid assets/total liabilities

Cash Ratio

It is helpful when an organization can only spend its money paying off its debts. If the cash ratio is one or higher, the company is safe.

Cash Ratio = (Cash and cash equivalents + Short term investments)/ the current liabilities.

The organizations only use these methods to determine their liquidity. However, the crypto market-ready data is fed to wallets, exchanges, and other crypto platforms. An investor only needs to look for information about their holdings’ trading volume and circulating supply.

Do Assets Like DeFi and Stocks Require Liquidity?

Liquidity is vital in a market since it becomes tough to convert the assets to currency if unavailable. For example, one may own a costly possession, but if there are no willing buyers, the possession may sell at low prices.

However, one can easily convert very liquid assets into currency in total value and minimal costs. Therefore, the companies that own publicly traded assets should have enough liquidity to allow for fair and accessible trading.

Illiquid DeFi: Why Some DeFi Assets Harbour Massive Liquidity

Since most DeFi tokens are new in the market, some fail. Others may get delisted from exchanges. If such an occurrence happens, the DeFi loses its liquidity since there are no market makers and takers. As a result, that asset is known as Illiquid DeFi. However, this DeFi can be liquidated through OTC traders who hold large amounts of ‘valueless’ DeFi, hoping that it will gain value in the future.

The most liquid DeFi assets are the ones that have very active market makers and takers. However, to achieve this, the DeFi asset must be appealing to traders and mostly the whales. The whales’ transactions are essential since their buy and sell orders significantly move the market and trading volumes.

How Does Liquidity Affect the DeFi Market?

Since liquidity of a DeFi asset is the degree to which a trader can convert their holdings to fiat currency at the current market value, it is essential. Below are some of the reasons why DeFi requires healthy liquidity.

Liquidity Helps it to Accelerate Transactions

When a DeFi market is highly liquid, market making and market taking take place very fast. As a result, anyone can trade that asset quickly since they don’t have to wait for a market maker or taker’s greenlight.

It Simplifies the Trading Process

When only a few people are willing to sell or buy an asset, the trading process slows since one must wait to sync with other traders. However, high liquidity simplifies this process since sellers and buyers are readily available.

Liquid Assets Have a Store of Value

Highly liquid assets have a longer lifespan since many traders are willing to continue investing in them. As a result, the probability of such assets losing value is minimal.

In the case where the liquidity of a DeFi asset falls below the normal, the following happens:

The Market Becomes Insolvent

When the liquidity of an asset falls below the 1:1 ratio with its liabilities, its market becomes insolvent since no one can convert it to cash. As a result, the investors’ holdings become valueless.

The Asset Loses Its Value Sharply

A sharp decline in the value of a DeFi asset may occur if its liquidity starts declining. This devaluation can happen if more sellers than buyers turn up, leading to significant losses.

The Selling Process of the Asset Becomes Hectic and Uneconomical

Once the liquidity of a DeFi asset starts declining, the selling process becomes hectic since there are more sellers than buyers. As a result, one uses many resources while liquidating their holdings.

The Transaction Speed Reduces Significantly

With low liquidity, the transaction speeds of trades also become slow. The rate reduces because there are too many sellers than buyers, which forces the lucky sellers to liquidate their holdings at a throw-away price.

Conclusion

To sum up all of the above, investors must learn how to track trading data of DeFi assets before investing in them. Several tools like Bscscan and Etherscan offer the current market data of each token that rely on their networks. Other sites like Coin Market Cap and trading exchanges also provide similar data.

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