Liquidity in Decentralized Finance (DeFi)

The essence of yield generation in DeFi

Sep 20, 2022
The cryptocurrency and financial markets both depend on liquidity. It is a process that swiftly and effectively turns assets into cash while preventing sharp price fluctuations. Uniswap is a great example of using liquidity to provide exchanging of (digital) assets without big fluctuations. A great understanding of how liquidity works in the blockchain ecosystem is pivotal to investing in the space.
When looking under the hood of many DeFi applications, liquidity is always needed to generate a well-functioning financial product. Without them, many different applications would not work efficiently, or would not work at all. Therefore, liquidity as such is an important metric to analyze and keep track of when investing in DeFi protocols since it is the lifeblood of the application. It can come in different forms, such as:
  • Liquidity Pools
  • Multi Asset Liquidity Pools
  • Liquidity Vaults
  • Target Liquidity Pools

Liquidity pools

A digital stockpile of cryptocurrencies locked in a smart contract is referred to as a liquidity pool. As a result, liquidity is established, allowing for quicker and more efficient transactions. A major use case of a liquidity pool is automated market makers (AMMs) such as Uniswap. Users of an AMM platform contributes tokens to liquidity pools in the form of two assets, for example ETH/LINK, and the AMM's internal mathematical algorithm determines the price of the tokens in the pool. The providers of such pair-based liquidity, earn a part of the swap-fee that belongs to their liquidity provision each time someone uses the application to swap the assets.
Other examples of liquidity can come in the form of multi-asset liquidity pools. Such pools have a downside that the liquidity provider is forced to have exposure to more assets to become a market maker for such pools. However, this can be seen as a positive for some because of lower volatility, particularly when (a part of) the basket is a stablecoin further dampening the variance while earning yield. Examples of protocols that found product-market fit and utilize multi-asset liquidity pools are for example Curve Finance and Balancer Finance.

Liquidity vaults

Another form of liquidity often utilized in DeFi Protocols are Vaults. Yearn Finance popularized Vaults in 2020 during the DeFi summer boom. Vaults are pools of funds with an associated strategy that aim to maximize returns on the assets inside the vault. Investors can save a lot of time by using vaults instead of spending that time looking into the best on-chain yield farming, earning, or investment tactics.
Smart-contracts are ideal vehicles to create investing strategies in the form of Vaults. Whether it is to increase the risk/reward profile, hedge against specific events or attempt to create automatic yield farming strategies, it can all be codified. In 2021, Vaults themselves became a ‘best practice’ in DeFi, particularly with DeFi Options Vaults, often abstracting away complexities while generating yield.
A clear downside to such practices is the possibility that the investor does not understand the structured finance product; it provides liquidity and does not understand the risks. Despite these risks, the adoption of Vault based applications has exploded with many many projects working with such systems:
Fourstack Capital is an investor and user of some of these Defi Protocols. We believe that using protocols that utilize these forms of liquidity provision can create higher risk-adjusted returns on blue-chip crypto-assets while also potentially providing an interesting investment opportunity themselves.