DeFi’s Liquidity Hurdle

welcome to the twelfth issue of "alpha unhashed", aarnâ's fortnightly newsletter on a decentralized & intelligent financial future.

January 25, 2024 • Estimated Reading Time: 11 minutes

In this edition, we're taking a deep dive into the world of DeFi liquidity. We'll discuss why it matters, how safe liquidity pools are, and implications for aarnâ. And in our DeFi roundup, we cover: 

🇮🇳 Dilip Chenoy: 'Bharat Web3' Unleashes User-Centric DeFi 

🤖 LPs Tackling Impermanent Loss in Bullish Markets

📈 Inverse Crypto Funds Post-SEC Approval

Everything right from bid-offer sales to trade execution is influenced by market liquidity. Liquidity refers to the extent to which a financial asset can be purchased and sold quickly, and at stable prices. On a decentralised exchange (DEX), liquidity directly correlates with the amount of tokens locked in a liquidity pool. If there is not enough liquidity, holders may not be able to sell their tokens as and when they wish. So, without liquidity, there is no DeFi and the market becomes practically unusable.

DEXs allow permissionless exchange of crypto assets. And trading on DEX is enabled by people adding liquidity to trading pairs. Unlike centralised exchanges (CEXs), on a DEX, anyone can introduce a new crypto pair or boost an existing one by adding liquidity. Since smooth exchanges rely on having enough liquidity, DEXs encourage people to pitch in by sharing a slice of the fees with those providing liquidity creating a win-win scenario. 

The core architecture of composability in smart contracts, which essentially enables different protocols or DeFi products to be interoperable, is a foundational block for DeFi. Thin liquidity can completely break functionality / transaction flow in composable contracts, rendering transactions and products useless. So, liquidity is vital for DeFi given the fully automated flow of financial transactions. Some key vectors of implications from DeFi liquidity:

> safeguards investors against market manipulation: In crypto, liquidity defends against market manipulation. While deep and liquid assets such as Bitcoin or Ether make it challenging for unscrupulous actors or groups to manipulate prices, there are hundreds of low liquidity (can very well be high quality projects) long tail assets.

> imparts market stability: A liquid market is stable because it is characterised with a lot of active trading, that smoothly balances buying and selling. In other words, investors can buy or sell without much slippage (which is when the expected price of a trade is different from the price at the time the trade is executed) or big price swings.

> ensures informed investment decisions: Increased participation enhances liquidity and facilitates the flow of market information. This market engagement reduces volatility and provides traders with a more transparent view of market dynamics. Subsequently, this enhances their ability to analyse, make predictions, and ultimately make well-informed decisions. 

> controls volatility: In a trading pair, insufficient liquidity can disproportionately impact the prices of one or both crypto assets. In simpler terms, when liquidity is low, the accuracy of the value for one or both assets becomes uncertain.

Currently, the total value locked (TVL) in DeFi is $58.462 billion. Since its peak of $200bn in 2021, DeFi liquidity is increasing steadily. Though most of it is expectedly on Ethereum, chains like Arbitrum have an evolving and dynamic DeFi ecosystem. 

aarnâ protocol’s â_fi tokenization platform contracts are built on Ethereum and are also being custom integrated for Arbitrum with top composable projects. Liquidity will be key to how â_fi structured products perform and attract TVL. 

One of the core products being designed at aarnâ is â_fi802, an AI output injected vault that automatically swaps in and out of top algo predicted assets every week. For liquidity considerations, the model takes a universe of 55 top tokens of Uniswap v3, which is the dex used by â_fi for swaps. As liquidity increases in more tokens, â_fi802 can have a wider and deeper universe of tokens to predict from. Watch this space, â_fi802 will be launched soon. Our advanced deep learning based (LSTM) model is generating 100%+ returns in backtests over a year.

The recent approval of spot Bitcoin exchange-traded funds (ETFs) in the US, 11 Bitcoin ETFs, will help attract new users into crypto. As of last count, almost $28bn had flowed into the Bitcoin ETF’s in less than 10 days, overtaking silver ETFs! As wider adoption happens, users will start gravitating to interact with crypto directly, ultimately DeFi, and this will lead to substantial liquidity flow into DeFi. We also believe that wider high level adoption via derived products like ETFs will ultimately lead to initiation into DeFi asset management!

The marketplace has come up with several ways to infuse DeFi with liquidity: 

> liquidity provision: Liquidity provision is when an investor deposits cryptocurrency into a liquidity pool, which enables trades on DEXs. By doing so, liquidity providers earn a portion of the trading fees paid by users who trade on the DEX.

> yield farming: Yield farming is a type of liquidity provision in which tokens are locked up or staked in a smart contract to earn more tokens or rewards. To engage in yield farming, a user must deposit their tokens into a liquidity pool after which they receive tokens representing their share of the pool in exchange for providing liquidity. 

> incentive program: DeFi platforms roll out incentive programs to attract liquidity providers. Users who contribute liquidity can earn extra tokens, governance rights, and other perks. These incentives make participating in DeFi not only rewarding but also boost liquidity. 

> cross-platform integration: Connecting with other DeFi platforms or protocols enables a smooth exchange of assets across different systems. This interoperability between platforms enhances overall liquidity in the DeFi ecosystem, facilitating the unrestricted movement of assets between various projects. 

> community engagement: Nurturing a participative community is key to drawing more users to DeFi. When people actively join discussions, share their thoughts, and bring in new members, it helps the community thrive. As the user base expands, so does the liquidity, with more people participating in both trading and adding liquidity to the platform. 

> liquidity providers: Market makers and liquidity providers play a vital role in infusing liquidity, especially in new crypto assets. Most market makers are comfortable in the realm of providing liquidity on centralised exchanges. This will change as DeFi is evolving fast, and they are key participants and could provide a surge to DeFi liquidity beyond its steady incremental growth.

In general, liquidity pools are safe, but need close monitoring if you’re a liquidity provider, as price movements can impact you adversely. Also, liquidity pools are exposed to onchain security risks, but evolving as overall blockchain security improves. We explore these two aspects of liquidity safety in pools.

All liquidity providers face the risk of an impermanent loss. One of the complexities that probably makes market makers shy off DeFi.  This loss occurs when you add coins to a pool, and market volatility changes their value. If one coin becomes pricier outside the pool, arbitrage traders exploit the difference, causing you to have less of the expensive coin and more of the cheaper one. Selling at this point makes the impermanent loss permanent, but leaving your coins in the pool might resolve the loss over time. 

Fortunately, you earn money from transaction fees and bonus tokens, which can offset the loss. Impermanent loss is less of an issue in stable pools with frequent trading.

Additional liquidity risks include smart contract issues, like misplacements or vulnerabilities, which could lead to hackers draining pool liquidity. There's also the risk of rug pulls, where project managers hype up a token, deposit a significant amount in a pool, and then drain it, causing substantial losses for liquidity providers. 

wrapping up

Infusing the ecosystem with new liquidity is critical for adding a layer of resilience to DeFi, and ultimately for innovation and wider adoption in DeFi. It’s sort of a cold start problem, but we’re fortunately well into more than $50bn liquidity already. For an order of magnitude change in DeFi liquidity, two vectors are vital: first, crypto users self-custodying assets, instead of holding on exchanges, this is already a trend. Second, the intersection between traditional finance (TradFi) and crypto would be vital, as big liquidity sits there. ETFs are probably the first step in this direction. 

DeFi liquidity is seeing very positive and steady signs and we expect it to double in 2024.

Liquidity providers face the spooky spectre of impermanent loss, especially as a bullish wave approaches. Depositing into automated market makers might feel like a rollercoaster, but according to Consello Digital Assets' Marc-Thomas Arjoon, LPs persist for many reasons.

With the SEC nod,  US asset managers are exploring leveraged Bitcoin exposure, eyeing Bitcoin options, and cooking up plans for more cryptocurrencies.

Top DeFi Tweets

@hmalviya9 explores the challenge of Liquidity Fragmentation in DeFi. Conquering this hurdle might just be the key to unlocking Multi Billion Dollar market caps down the road.

In the latest Chopping Block episode, @hosseeb, @Tomhschmidt, @rleshner, and @tarunchitra delve into the crypto ETF maze, dissect Tether drama, and peek into asset-backed securities and crypto casinos. NFTs get a second look beyond digital art, and the Solana phone's crypto-tech integration gets a shout-out.

According to @OdiCrypt Liquidity Staking Derivatives are the DeFi cash cow post Ethereum's PoW to PoS switch! 

aarnâ's mission is to decentralize the alpha value chain, empowering everyone to benefit from DeFi’s transformative potential, and helping manage one’s crypto & digital assets wealth. >> Try our engine

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