WingRiders Understanding the importance of liquidity

Hey Riders, today we are going to discuss the very important topic of liquidity and how it affects various outcomes in swapping and the provision of liquidity. Let’s start off by understanding what liquidity is, why it is important, and what to be aware of in terms of slippage, price impact, and impermanent loss.

In the world of cryptocurrencies, “liquidity” refers to how easily a digital currency or token may be changed into another digital asset or cash without affecting the price, and vice versa. Since liquidity is a measure of how much outside demand and supply there is for an asset, a market that is deep and has a lot of liquidity is a healthy market. Also, if everything else is the same, 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 aggregate value of crypto assets placed in a decentralized finance (DeFi) system, or in DeFi protocols in general. It has evolved as a critical statistic for assessing interest in that specific segment of the cryptocurrency business.

TVL covers all coins placed in all of the DeFi protocols’ functions, including:

staking, lending, and liquidity pools.

Importantly, it does not represent the predicted yield on these deposits. It solely refers to the current worth of the deposits.

The TVL of a project changes when customers make new deposits or remove their assets. It is continually altering in accordance with the shifting dollar value of all cryptocurrency assets. Some or perhaps all deposits in a DeFi system may be denominated in its native token. When the protocol’s native token gains in value, so does its TVL.

TVL may be used by investors to determine if a DeFi project’s native token is adequately priced. The token’s market cap may be high or low in relation to the project’s TVL. The more intense the link, the more the token may look overpriced or undervalued.

Others argue that because most crypto projects are open source, they live and die based on community acceptance and network effects derived through widespread use. Any honest metric should consider value produced for users, not only locked value. They also highlight TVL as an outmoded and AMM-specific measure and say that we require measures that assess inherent value. Only by assessing the intrinsic value can we determine how much the project is truly worth. The most important thing to look at is the value a protocol provides and how well it does that. Everything else is less important and can be manipulated. They also say that this is not to argue that we should never study financial measures, but the map does not always correspond to the region.

Many decentralized exchanges (DEX), such as WingRiders, rely on liquidity pools. To form a market, users known as liquidity providers (LP) combine the equal values of two tokens in a pool. In exchange for putting their money into the pool, they get trading fees on trades that happen in their pool based on how much liquidity they have in the pool as a whole. So a liquidity pool is a collection of tokens that have been locked up in a smart contract. Liquidity pools are used to support decentralized trading, lending, and a variety of other activities in Decentralized Finance (DeFi).

A liquidity pool, as previously stated, is a collection of tokens placed into a smart contract by liquidity providers. When you execute a trade on an AMM, you do not have a typical counterparty. Instead, you are trading against the liquidity in the liquidity pool. There does not need to be a seller at that time for the buyer to purchase; just adequate liquidity in the pool is required.

When you purchase a token on WingRiders, there is no typical seller on the opposite side. Instead, the algorithm that determines what occurs in the pool manages your activities. Furthermore, this algorithm determines price depending on transactions that occur in the pool.

So it is clear that high liquidity in a pool is important, but what happens when a pool has low liquidity?

Low liquidity in a pool can cause a big difference between how much a token transaction is expected to cost and how much it actually costs. Because there are so few tokens locked up in pools, token changes in a pool, whether as a consequence of a swap or any other activity, produce higher imbalances. Traders will not face much slippage if the pool is extremely liquid.

One of the risks of trading in a low liquidity pool is “Slippage”. When you trade on a DEX, you are basically 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 price slippage. The less liquid the pool, the more likely slippage will affect your deal. Nobody likes getting fewer tokens than they anticipated. You control slippage on the WingRiders DEX. Just access the “Transaction Settings” by clicking on the “settings” cog wheel in the top right-hand corner of the swap panel, where you can access the transaction settings, you will see the different options available.

WingRiders DEX: Slippage tolerance setting

The “Slippage tolerance” defines how large a change in the exchange rate you are willing to tolerate when creating your swap request. This is important, as every request made before yours slightly changes the exchange rate between the tokens. There are some default slippage tolerance values in the first row, and in the second row, you can set your own. If you set a very small tolerance, there is the possibility that your request will not be fulfilled, and if you set a high percentage, the exchange rate may move considerably.

The second issue to look out for when trading against liquidity pools is price impact. The effect 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 quantity of liquidity in the pool. Price impact can be especially severe in illiquid markets or pairs, causing a trader to lose a significant portion of their capital. The price impact is also very clear to see when carrying out a swap on the DEX. This is displayed just below the SWAP UI when you click on the arrow next to “Total fees.” In the image below, you can see the price impact on this trade is 0.769%.

WingRiders DEX: Swap Price Impact indicator

Finally, it’s important to understand what impermanent loss is. Though this concept is not directly connected to liquidity, nevertheless something to be aware of when providing liquidity. The drop that happens when the price of the assets you’ve deposited changes between deposit and withdrawal is referred to as an “Impermanent Loss.” If the difference is greater, the loss is greater; if it is smaller, the loss is smaller. The loss arises as a consequence of placing two cryptocurrencies into a liquidity pool and withdrawing them later with a value differential that is less than what you would have received if you had kept the coins in your wallet. The impermanent loss is only felt when 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 watch out for when working with liquidity pools.