Why does Defi need Liquidity?
Why does Defi need Liquidity?
Liquidity is an up-to-date measure of the ability to quickly convert assets. In defi, liquidity is the grease that enables protocols to create cash flow for their tokens. If a trader wants to leverage 10x long on a decentralized protocol like GMX on Arbitrum, GMX will need liquidity to provide that 10x leverage of the asset being traded. If a protocol wants to offer lending as a service, that protocol will need a liquid amount of the desired asset in order to be able to lend it. If a trader wants to swap ETH for wrapped BTC, a swap protocol like Uniswap needs to have enough liquidity to complete that swap.
In traditional finance and on centralized crypto exchanges liquidity is typically in dollars, and either comes from investors, or in banking terms is in fractional reserves. This means that investors are profiting off of the fees incurred by trading crypto for cash, or the exchanges are able to “cash flow” by only paying out the net of long vs. short trades (minus fees) which often ends up in a net profit.
In defi this is not the case, because on-chain data is verifiably 1:1, each token or coin needs to be accounted for and therefore a fractional reserve system, where lending more than a protocol has in reserves is impossible. Though this is one of the fundamental advantages to defi, it is also one of the biggest challenges. Every trade on decentralized applications must have some sort of liquid collateral in order to function smoothly.
GMX is the largest decentralized perpetual futures exchange. In order to provide traders with the ability to leverage their assets so they can 10x long wBTC, GMX needs liquidity in the form of GLP to offer this service. GLP is made up of 50% blue chip crypto assets like ETH and wBTC and 50% stable coins, primarily USDC. GLP is the counter party to the leveraged traders on GMX. Why would someone want to provide liquidity in the form of GLP? Well, because it has historically earned GLP holders a 15%-25% APR paid in ETH. GLP provides real yield to the holders as they receive 70% of protocol fees which has become a popular investment strategy on Arbitrum.
Here’s another example. A lending application like Aave. Aave requires any potential borrowers to first become a lender. Unlike traditional finance, there are no credit scores and because borrowing is done permissionlessly, it requires the borrower to provide adequate collateral. In defi this concept is known as over-collateralization. In terms of Aave, one can not borrow more than 80% of the value of the supplied collateral. Let’s say that Aaron would like to supply Aave with ETH on arbitrum. He sees that the current rate of return on supplied ETH is .39%. It’s not a great rate of return, but he speculates that the crypto market is heading into a bull market and he doesn’t want to sell his ETH. He knows that he’d get liquidated on Aave if he borrowed more than 80% of the value of his ETH but would like to take advantage of the value available in his ETH. In this case he decides to borrow $800 of USDC for every 1 ETH he lends to Aave.
Aave collects 2.97% APR and pays a portion of that borrow fee to the lender. Though Aaron has to pay to borrow $800 on Aave, he knows he can get roughly 15%-25% APR providing liquidity to GMX in the form of GLP, and if his lended ETH ever nuked, he could cash out his GLP position and repay the borrowed USDC as long as ETH was valued at or above $1000 dollars.
The above is the basis of the term yield farming. Just like in traditional finance, there are many assets in the Ethereum ecosystem that provide an investor a profitable yeild. Providing liquidity as an asset is the basis of how swap dapps like Uniswap opperate. Liquidity providers are incentivized with trading fees (yield) in order to want to lock up their assets so that they can be swapped on a Uniswap.
In defi, the users permissionlessly get to be like and earn like banks in the traditional finance system. Though institutional money is entering the crypto market more and more every cycle, it is the retail trader that is profiting the most from this permissionless yield earning system. In the case of Uniswap, it is so decentralized that all trading fees are paid directly to the provider of the liquidity. A financial system without middle men can and does truely exist in the world of crypto in the form of defi.
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