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Common Liquidity Problems

December 14, 2023

Cryptocurrencies are known for their volatility, primarily caused by speculative and unpredictable customer demand. Even minor fluctuations in demand may lead to significant price changes, and any liquidity shortage is quickly noticed. Even the most popular assets are not immune to significant repercussions in the event of a substantial trader outflow and subsequent liquidity decrease. Therefore, it is unsurprising that liquidity is paramount in the crypto industry. 

Another challenge is the current state of the blockchain universe, which is still quite fragmented and disconnected. As the popularity of cryptocurrencies grows and more people enter the market, a wider range of platforms, products, and services emerge. As the blockchain landscape becomes more diverse, liquidity naturally becomes more dispersed and less accessible.

Despite the emergence of more advanced solutions on the market, liquidity issues remain. So, what are the most common liquidity problems, and are there any potential solutions? Let's take a closer look.

Liquidity Problems on CEXes 

Centralized exchanges (CEXes) rely on order books to match crypto buyers with sellers. However, they sometimes face a thin order book. This problem occurs when the depth of buy and sell orders becomes insufficient for a seamless trading experience. As a result, users struggle with increased volatility and price slippages, making it challenging to execute large orders without significantly impacting the market prices.

In order to address thin order book issues, exchanges implement various strategies to incentivize liquidity providers. These strategies include, for example, offering maker rebates or share of user fees. Another way to maintain sufficient liquidity is to employ market-making bots to enhance order book depth.

The second problem associated with liquidity in centralized exchanges is wash trading. It is a manipulative trading tactic that helps to create a fake volume, creating an illusion of high liquidity and interest from other traders. This market manipulation artificially boosts prices and misleads traders, tricking them into buying affected assets at unreasonably high prices. 

Note that such a practice is not exclusive to greedy traders. Crypto exchanges can also do wash trading to artificially increase their trading volumes, making themselves appear more productive or more liquid than they actually are. That could lure crypto users looking for a new platform for trading and managing their assets. The use of blockchain analytics can help to identify wash-trading activities. However, it can be challenging for less experienced users. 

Liquidity Problems on DEXes

Decentralized exchanges (DEXes) operate differently than centralized exchanges, using automated market makers (AMMs) with liquidity pools and relying on liquidity providers instead of market makers. In this model, providers stake their assets in pools, which AMMs use to trade with traders. However, despite the efficiency of this model, many decentralized exchanges and apps still struggle with lower trading volumes compared to their centralized counterparts, especially the largest centralized platforms. Low liquidity can result in wider bid-ask spreads, increased slippage, and a less favorable trading environment for users.

Liquidity struggles are often linked to the inability to attract and retain enough liquidity providers. These providers carefully choose platforms, comparing conditions to maximize profits and considering their own risk tolerance levels. As a result, they tend to withdraw their funds and transfer them to competitors if they offer better returns. Additionally, some liquidity providers become deterred by the risk of impermanent loss, which occurs when the value of their assets in a liquidity pool is lower than if they had held those assets individually. Such losses appear due to fluctuations in market volatility. DEXes and other DeFi projects counteract impermanent loss by providing liquidity providers with a share of fees and other incentives, competing to attract as many providers as possible.

Collaborations between DeFi projects can also help fight against insufficient liquidity. For instance, they can collaborate on aggregating and connecting liquidity across networks to maintain sufficient levels for their users.

Exchange Dependency

Liquidity struggles can occur regularly, but larger-scale liquidity problems are less common and can affect the entire industry. These crises can be caused by unexpected economic shocks or serious miscalculations by major market players, such as a prominent exchange or lending protocol. 

Many cryptocurrencies heavily rely on a limited number of exchanges for liquidity. When a large portion of trading occurs on a handful of platforms, it creates a vulnerability known as exchange dependency. If one of these exchanges experiences downtime or faces other substantial issues, it can lead to a liquidity crisis for the associated crypto assets.

To mitigate exchange dependency, the crypto industry benefits from developing DEXes and other DeFi solutions for trading assets. 

Liquidity Fragmentation & Frozen Liquidity

Liquidity Fragmentation is another issue that has a massive effect on liquidity. The crypto market is highly fragmented, with the same assets traded across numerous exchanges and trading pairs. This fragmentation can lead to liquidity being dispersed, making it difficult for traders to find counterparties for their transactions. 

Sometimes fragmentation goes beyond different platforms, with the same assets traded across blockchains. It is possible due to cross-chain bridges that wrap tokens, enabling users to use them on other blockchains apart from the original one. The wrapping process requires locking original assets in smart contracts (or burning them in some cases), which can thin liquidity considerably over time. 

Aggregation and interoperability protocols can partially address the issue of fragmented liquidity in the DeFi space. By pooling liquidity from various platforms, pools, and networks, they can help users access liquidity collected across the blockchain space and enjoy a more streamlined trading experience. 

Another issue associated with fragmentation is frozen liquidity. This term refers to liquidity that cannot be actively used because it is locked somewhere, for instance, in a bridge's smart contract or a pool. This phenomenon may also have a negative influence on liquidity across networks.

Final Thoughts

The crypto market is highly volatile, and liquidity can disappear quickly during periods of heightened uncertainty. Unpredictable market conditions, often caused by external events or regulatory developments, can catch traders off guard and lead to liquidity shortages.

As the cryptocurrency industry continues to grow and evolve, it is vital to ensure its long-term sustainability by addressing liquidity issues. A diverse and resilient liquidity ecosystem can make the crypto market more attractive to institutional investors and pave the way for broader adoption. 

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