Dubai, UAE, 14th December 2023, The volatility of cryptocurrencies is widely recognized. Even tiny fluctuations in demand can result in considerable price changes, and any liquidity shortage is quickly detected and discussed. Large outflows of traders and subsequent reductions in liquidity can have serious consequences, even for the most popular cryptocurrencies.
Another issue is the current state of the blockchain universe, which is still quite fragmented and disconnected. As the blockchain ecosystem becomes more diverse, liquidity becomes more dispersed and less attainable.
Despite the introduction of more sophisticated solutions on the market, liquidity issues persist. So, what are the most prevalent liquidity problems, and are there any potential solutions?
Liquidity Problems on CEXes
Centralized cryptocurrency exchanges (CEXes) rely on order books to match buyers and sellers of digital assets. However, they may sometimes face a problem known as a thin order book. This issue arises when the number of buy and sell orders is inadequate to facilitate a smooth trading experience. As a result, users may experience increased volatility and price slippage, making it difficult to execute large orders without significantly affecting market prices.
CEXes implement various strategies to address the problem of thin order books. For instance, they may offer maker rebates or a share of user fees to motivate market makers to maintain trading. Another possible solution is to use market-making bots to enhance order book depth.
The second problem associated with liquidity on CEXes is known as wash trading. It is a market manipulation tactic that helps to create an illusion of high liquidity and boost prices, attracting interest from other traders.
It is worth noting that malicious, greed-driven traders are not the only ones engaging in this practice. Crypto exchanges themselves may also use wash trading to inflate their trading volumes, making themselves seem more liquid and robust. While blockchain analytics can help identify wash-trading activities, it can be challenging for novice users.
Liquidity Problems on DEXes
Decentralized exchanges (DEXes) work with automated market makers (AMMs), which use liquidity pools and rely on liquidity providers to supply those pools. Still, DEXes struggle with lower trading volumes, especially compared to the biggest CEXes.
The inability to attract and retain enough liquidity providers is one of the leading causes of liquidity problems on decentralized platforms. Liquidity providers are selective and tend to withdraw their funds if they get better conditions elsewhere. Moreover, they are cautious about impermanent loss, which may discourage some liquidity providers.
To draw enough providers and prevent possible losses, which can demotivate them, DEXes and other DeFi projects offer different incentives, competing to provide the best conditions.
At times, the liquidity of some crypto assets can become heavily reliant on only a select few exchanges, resulting in exchange dependency. Because a considerable portion of trading takes place on these few platforms, issues on even one of them can lead to a liquidity crisis.
However, the increasing popularity of DEXes and other DeFi solutions can help to diversify and expand the number of platforms that support crypto assets, thereby mitigating the risks associated with this severe vulnerability.
Liquidity Fragmentation & Frozen Liquidity
Fragmentation of liquidity is the next concern that greatly impacts crypto liquidity across the crypto market. Since the same assets are traded on many exchanges and in different pairs, liquidity spreads throughout platforms, complicating users’ search for sufficient liquidity.
In some cases, fragmentation extends beyond different platforms, as the same assets are also traded across blockchains through cross-chain bridges that wrap tokens and enable users to use them on other chains. As the wrapping process involves locking original assets in smart contracts (or burning them in some cases), it can notably reduce liquidity over time.
Another issue, also connected to cross-chain bridges but not exclusively, is frozen liquidity. This term refers to liquidity that is locked and thus cannot be actively used in trading activities, also negatively impacting available liquidity.
One of the solutions for such issues is aggregation and interoperability protocols. These protocols pool liquidity from different sources to offer users a more straightforward and efficient trading experience.
As the cryptocurrency industry continues to expand and develop, it is crucial to address liquidity concerns for the sake of its long-term sustainability and growth. This way, the crypto community can ensure a wider adoption of crypto assets and decentralized solutions globally.
Disclaimer: The views, suggestions, and opinions expressed here are the sole responsibility of the experts. No Finance Zeus journalist was involved in the writing and production of this article.