Getting to know Liquidity on Decentralized Exchange and Yield Farming?
In the Cryptoverse Liquidity is the key to the survival and success of an altcoin, without it, no one will invest in that cryptocurrency. When it comes to Monetary Policies and Acts In the Financial sector, the amount of fiat money in circulation should have a backing in reserve with the same value to maintain the inflation levels. In the crypto-verse, if we look at Stable Coins, it is claimed that they are backed with Fiat money and assets to maintain their stability.
I think the above image makes it easy to understand how liquidity works on centralized and decentralized exchanges. Mostly you might see some crazy gains on tokens if you check the coin market cap. Let's say the token was valued at $0.02 and maybe that token is listed on a Decentralized Exchange with a Liquidity of $10 000 provided and all of a sudden the token goes up to $5. You might be shocked, if you go and try to sell 10 000 tokens on that DEX your transaction will not go through due to low liquidity, or maybe they will offer you a lower price like $0.02. There are several cases where investors complain that they are failing to liquidate their tokens on DEX, e.g Squid-game hit a higher price of $2,861.80 but no one cashed out their monies.
When I first started investing in cryptocurrencies back in 2016, I would make sure that before I look into anything else, I would check the 24 Hour Trading volumes on the Coin market cap and this would give me a signal if the coin was Liquid or not. You might find a token with a higher price on the coin market cap e.g $5 and if you check on the market tabs you might see stars** there showing that the volumes might be below and can not be traded.
In the token above we can see that I circled some areas in red and they are areas of concern. Volume on 24H is not available and on the market, tab volume has got stars and liquidity is not updated and there is no investor confidence. So if you happen to buy this token you might succeed but when it comes to selling it you might face challenges.
How does Liquidity Play a Role in Yield Farming and Defi?
These there are Yield Farming and Decentralized Exchanges, on these you will see a menu like that on the screenshot below. Investors will do what is called Yield Farming and provide Liquidity pools through depositing 2 different assets e.g you deposit Binance USD (BUSD) worth $100 and then you deposit another volatile token like Ethereum worth $100 and they are locked and the liquidity providers will earn from the fees charged on transacting. The reason they do so is to provide liquidity whenever a transaction is about to be conducted.
There are also other cases, for example, you want to swap from Matic to Aave and maybe you will see that your transaction is being transacted through a different route e.g your Matic will be converted to Ethereum, and then from Ethereum to Aave. The reason for that is, the Matic/Aave pair might not be there and maybe there is MATIC/ETH then ETH/AAVE pair so your Matic will be traded on the MATIC/ETH and the ETH received from that trade will be used to buy your Aave and the trade is completed.
The image above shows the process of trading WMATIC to AVVE and the trade is taking the Ethereum route to prove what I just explained. Then earlier I talked about Liquidity providers being paid from the fees generated from the transactions depending on the amount of liquid they provided.
So an investor can choose to stake his/her cryptocurrency as a single pair e.g you just stake your Bitcoin or either you chose to join the liquidity pools like Harvest Finance and you deposit 2 pairs with the same value and when you jump into that you have to know that there are Liquid risks involved such as Impermanent losses. So do some research before you get in so that you will know what you are getting yourself into and avoid unnecessary surprises.
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