What is Liquidity?

At its core, liquidity refers to how easily an asset can be bought or sold without causing a significant change in its price. In traditional finance, liquidity is crucial in markets like stocks or currencies. In #DeFi#, liquidity is even more important because it enables trading without the need for centralized exchanges like traditional stock markets.

Liquidity pools are where users deposit tokens so that others can trade them. Without liquidity, trading would be slow, expensive, and impractical. 

For instance, in the early days of crypto, when someone wanted to sell Bitcoin they would need to find someone who wanted to buy it. Not only is this impractical, it also carries security risks that are no longer a concern with the #trustless# solutions available today – for more information on this check out our Crypto and blockchain: Is it safe?LINK article.

How Liquidity works:

So in its simplest form a liquidity pool might look like this:

The liquidity pool maintains a 50/50 split. Let’s imagine we have a liquidity pool of $1,000 worth of $VESTA and $1,000 of $METIS. Someone uses $100 worth of $METIS to buy $VESTA. 

Now though we have less $VESTA in the pool and more $METIS; the pool “balances” the price of $VESTA to rise in comparison to $METIS so that a 50/50 split is maintained. This would be an example of V2 Liquidity (see below). 

When a user makes a trade in the pool, there will be a small trading fee. Generally this fee is split between the protocol that is hosting the liquidity pool and the users who are providing the liquidity within the pool.  

Note: Liquidity pools are much more advanced now than the above example. We dive into the most common types below.

Why is high liquidity important?

We covered above why liquidity itself is important, in that it allows users to trade their tokens in an efficient and trustless manner. So why is having “lots” of liquidity important for a token or project?

Note: when we talk about “high” liquidity we mean in terms as a percentage of total supply. Check our Evaluating TokensLINK article for more on this. 

Reduces Slippage:

Slippage is the difference between the price you expect for a trade and the actual price you get. High liquidity reduces slippage, ensuring that traders can execute large trades without drastically affecting the price.

Supports Market Stability: 

Markets with higher liquidity are typically more stable. If liquidity is too low, even small trades can cause significant price swings, making the market more volatile and unpredictable.

Types of Liquidity in DeFi

As mentioned above there are many different ways that liquidity is managed on decentralized exchanges, with each having its own advantages and disadvantages. 

Below we’ve listed the two types you’re most likely to encounter. 

This is far from exhaustive; many platforms offer systems that are either a modified version of one of the below, a “hybrid” combination that seeks to leverage the advantages of each, or their own totally different system. 

Traditional Liquidity Pools (V2 Model)

The V2 model is a simple solution that provides “uniform liquidity” across a pool. Well known examples include UniSwap V2 and SushiSwap. 

The example above in the What is liquidity section would be an example of the V2 model. 

In this model, liquidity providers (LPs) supply tokens to a liquidity pool that covers the entire price range of an asset pair – this makes it “uniform”. 

For example, if you’re providing liquidity to an ETH/USDC pool, you are effectively providing liquidity for all possible prices of ETH, from $0 to $10,000 (or higher).

How V2 liquidity works:

In a V2 system, liquidity providers deposit two tokens into a pool (e.g., ETH and USDC). The pool uses an automated market maker (AMM) formula to execute trades. The most common formula is x * y = k, where:

• x is the amount of one token in the pool (e.g., ETH),
• y is the amount of the other token (e.g., USDC),
• k is a constant that ensures the value of the pool remains balanced.

So, for instance:

V2 Example in Action:

Let’s imagine a V2 VESTA/USDC liquidity pool with:

• 10 $VESTA and 10,000 USDC
• Using the x * y = k formula, the product of the token amounts (10 * 10,000 = 100,000) remains constant.

So: 

X = the amount of $VESTA

Y = the amount of USDC

K = the constant value set when the pool was formed. In this case 100,000. This always stays the same. 

With the above pool each $VESTA would be worth 1,000 USDC

Let’s imagine someone tries to buy $1,500 in USDC of $VESTA

• The buyer deposits 1,500 USDC.
• This brings y up to 11,500. 
• During the trade the liquidity pool accounts for the shifting price. 
• To find the new amount of $VESTA we can do k/y = x.
• So… 100,000/11,500 = 8.7 (roughly)

This means the user receives 1.3 $VESTA, the new price is 1,321.8 USDC per $VESTA. 

Concentrated Liquidity (V3 Model)

The V3 model, introduced by UniSwap V3, solves some of the inefficiencies of V2 by allowing liquidity providers to “concentrate” their liquidity in a specific price range. 

Instead of spreading liquidity across the entire price range, liquidity providers can choose the price range they believe will see the most trading activity. 

How V3 liquidity works:

In V3, liquidity providers select a narrow price range where they want their liquidity to be active. 

For example, if you believe ETH will trade between $1,500 and $2,000, you can provide liquidity only in that range. This means your liquidity is more concentrated and more efficiently used for trades happening in that range. 

In action this means that whilst in the V2 system you always hold a certain amount of each token (unless one of them goes to zero), in V3 your position becomes entirely one sided when prices move outside of your selected range. 

This also means that, for that range, there is a higher effective liquidity “volume” than would be present under a V2 system; this means that the price will be heavily less impacted in heavily concentrated ranges. This can be good in terms of adding some stability to assets, but can also make price gains slower. 

Note: V3 positions often require more active monitoring to ensure you are providing liquidity in a range that will see volume. 

Advantages and disadvantages of V2 and V3 liquidity 

When we talk about advantages and disadvantages it is important to distinguish who we are talking about. A feature that might be an advantage for a trader might also be a disadvantage for the project. 

We have broken down some of the key considerations in the table below, but it is worth noting that often #DEXs# have come up with innovative solutions to the potential disadvantages listed, especially with V3 pools.

For Traders:	V2	V3
Liquidity Availability	Always available across all price ranges	Concentrated liquidity in selected ranges; may drop off if price moves outside the range, less likely to be a concern in larger pools.
Slippage	Lower slippage during extreme price movements	Lower slippage in active price ranges, but can increase outside those ranges
Trade Pricing	Consistent pricing, but less efficient in high-volume ranges	More efficient and competitive pricing within the concentrated ranges
Ease of Use	Simple and predictable liquidity and fees	More complex as liquidity may not always be concentrated where you want to trade
For Liquidity Providers:
Effort Required	Passive – No need to monitor or adjust positions	Active – Requires monitoring and adjusting liquidity based on price movements
Earning Potential	Lower overall due to spread-out liquidity	Higher earning potential if liquidity is concentrated in active ranges
Risk of Impermanent Loss	Always present, but liquidity is spread across all prices	More pronounced, especially if prices move outside your chosen range.
Control Over Liquidity	Limited – Liquidity is spread evenly over all prices	High control – Can focus liquidity where you expect the most trading to happen rewarding users who actively manage their position.
For Projects:		*NOTE: many solutions exist to the potential disadvantages for projects on individual DEX’s
Price Impact/market stability	Price is more volatile in general, but volatility is evenly spread across the range. Price can also rise more easily.	Price is more stable when within the range of strong concentrated liquidity, but can become even more volatile when moving outside those ranges. Price rises less easily, but also falls more slowly.
Liquidity Management	Less dependent on active liquidity management by providers	Projects may need to incentivize liquidity providers to actively adjust their ranges, ensuring consistent liquidity
Capital Efficiency	Less efficient, as liquidity is spread across all price ranges regardless of activity	More efficient use of capital in high-volume ranges, but depends on liquidity providers managing their positions actively
Incentive Design	Simpler, as liquidity is always available, making it easier to design broad incentive programs	More complex; projects may need to create targeted incentives to keep liquidity in specific ranges, ensuring sufficient liquidity coverage across price points

Liquidity Pool Rewards

So what exactly incentivizes people to use their tokens to provide liquidity?  Well, at its core users are incentivized through receiving a portion of trading fees. 

Everytime someone uses a #DEX# liquidity pool they will pay a small fee to the protocol itself. Generally a large portion of this will be shared with those who are providing liquidity, based on what percentage of the full pool they make up. 

Sometimes these fees will need to be claimed, other times DEXs #auto-compound# the rewards. 

These aren’t always the only rewards available to liquidity providers however, sometimes pools are ‘incentivized’ (this is often the case when you see crazy high #APYs#). We’ve listed the two main sources of this below. 

Note: Different DEXs advertise their APYs in different ways. Some include auto-compound them. So advertising assuming that you yourself are #compounding# your rewards every day. Some include an unlaunched token and guessing at the price it will have. Make sure YOU understand where any rewards are coming from.

Project incentives

As we covered above, having high liquidity (when compared to market cap) is considered a “good” thing by most projects and investors. This means that many projects (especially new projects) may add incentives for users to provide liquidity. 

This is generally (not always) in the form of the projects own tokens in the form of #emissions#. When this is the case you should be aware of the downward pressure on token price that emissions can have and decide for yourself whether or not the rewards are likely to outweigh this. For more on this check out our article on Evaluating tokensLINK.

Project incentives can also be used to encourage the type of liquidity a project wants to see; for instance if there is a price range that has little liquidity, they might incentive users to provide concentrated liquidity that covers that range.  

DEX incentives

Sometimes DEX’s themselves will have incentives to encourage participation in general or alternatively participation in a particular aspect of their DEX. This might be because they are new and want to drive traffic, because the market is slow, or because they are incentivized themselves in some way to do so. 

Which tokens are rewarded for this will vary depending on the motivation for the incentive; often they are the DEX’s own token or alternatively the Network’s token. 

Impermanent Loss

One of the most significant risks for liquidity providers is impermanent loss. This occurs when the price of one or both tokens in the liquidity pool changes significantly compared to when the liquidity was first provided. When the price changes (either increasing or decreasing), you  could end up with less value than if they had simply held the tokens without providing liquidity.

Let’s have a look at our example from earlier in the V2 Liquidity Section. 

Example refresher

Let’s imagine a V2 VESTA/USDC liquidity pool with:

• 10 $VESTA and 10,000 USDC
• Using the x * y = k formula, the product of the token amounts (10 * 10,000 = 100,000) remains constant.

So: 

X = the amount of $VESTA

Y = the amount of USDC

K = the constant value set when the pool was formed. In this case 100,000. This always stays the same. 

With the above pool each $VESTA would be worth 1,000 USDC

Let’s imagine someone tries to buy $1,500 in USDC of $VESTA

• The buyer deposits 1,500 USDC.
• This brings y up to 11,500. 
• During the trade the liquidity pool accounts for the shifting price. 
• To find the new amount of $VESTA we can do k/y = x.
• So… 100,000/11,500 = 8.7 (roughly)

This means the user receives 1.3 $VESTA, the new price is 1,321.8 USDC per $VESTA. 

Applying Permanent Loss

Now let’s imagine that you held 10% of this pool when it was first created, consisting of:

• 1 $VESTA (worth $1000)
• 1000 USDC (worth $1000)
• Total assets worth $2000

After the trade you withdraw your position, which is still 10% of the total. You get:

• 0.87 $VESTA (worth 0.87 * 1321.8… = $1150)
• 1150 USDC (worth $1150)
• Total assets worth $2300

This sounds great at first, you put in $2000 and took out $2,300. But let’s see what would have happened if you’d just held the tokens. 

You would have had 1 $VESTA worth $1,321 and 1000 USDC worth $1000 for a total of $2321.

The missing $21 is an “impermanent loss”. 

Impermanent loss also impacts you when prices drop because you end up holding more of the token that has lost more price. 

In a traditional liquidity pool it is up to you to decide how much of a risk impermanent loss is; when pairing assets that you believe will move up in price together it will be less. 

When pairing an asset you believe will rise rapidly in price with a stablecoin (like in the example above) you may need to account for more. 

Impermanent loss can be temporary, especially if the price returns to its original level, but it becomes permanent once you withdraw your liquidity. It’s important to calculate whether you believe the liquidity incentives will outweigh this loss.

Note: Some protocols offer mechanisms designed to reduce or negate impermanent loss. Make sure you understand how these work when deciding whether or not to provide liquidity.