The King of All Markets: Liquidity

If financial markets are an ocean, then liquidity is the water. Although definitions of liquidity vary between the availability of cash and the cash itself, one thing is for certain; just as an ocean cannot exist without water, a market cannot function without liquidity. Meanwhile, the flow of liquidity between markets can make or break them. Furthermore, the liquidity of a particular asset, cryptocurrency for example, is an important indicator of their viability as well as an essential element of their tradability. Thus, in financial markets, liquidity truly is king!

Understanding Markets: Why Liquidity is King

Before jumping into its importance, let us define the concept. Liquidity, in its most fundamental sense, refers to the ease with which an asset can be bought or sold in the market. This tradability often correlates with the availability of the asset and is therefore conflated with the relative quantity of the asset itself. Accordingly, liquidity is discussed in relation to an individual or group allocating their funds to an opportunity in addition to the liquidity of an asset or market itself. Nevertheless, liquidity in both forms is critical, with its importance having been recognised by numerous economists and financial theorists throughout history. For instance, Nobel laureate Eugene Fama highlighted liquidity’s role in ensuring that asset prices fully reflect all available information, as stated in his Efficient Market Hypothesis. 

The concept of liquidity is multifaceted, encompassing aspects such as market depth, immediacy, and tightness. Market depth refers to the exchange’s ability to handle large orders without significant price changes that occur following a trade, known as slippage. Immediacy is the speed at which orders can be executed. Finally, tightness refers to the spread between the bid (purchase) and ask (sale) prices. A market is considered highly liquid if it possesses depth, immediacy, and tight spreads in the order book, allowing for efficient price discovery and minimal transaction costs.

In the burgeoning world of decentralised finance (DeFi), liquidity takes on a newfound importance. Liquidity in these markets is often provided by liquidity providers (LPs) who pool their assets in smart contracts. These liquidity pools are used to facilitate trading activities on decentralised exchanges (DEXs), with LPs earning fees in return. The concept of Automated Market Makers (AMMs), pioneered by platforms like Uniswap, hinges on this principle of liquidity provision. The importance of liquidity in these markets cannot be overstated. It is the cornerstone upon which the promise of DeFi – a truly open, inclusive, and efficient financial system – is built. 

The Role of Liquidity in Driving DeFi Innovation

The management of liquidity and the maximisation of capital efficiency have been pivotal in driving the continued innovation of DEXs in the DeFi landscape. As the backbone of DeFi, DEXs have had to constantly evolve and adapt to the challenges posed by the unique characteristics of the crypto market, particularly its volatility and the fragmentation of liquidity. The quest for efficient liquidity management and capital utilisation has led to the development of novel mechanisms and protocols.

Uniswap, one of the pioneers of the AMM model, serves as a prime example of this liquidity-driven innovation In its initial iteration, Uniswap V1, the platform introduced the concept of liquidity pools, where users could deposit equal values of ETH and any Ethereum Request for Comment 20 standard token (ERC-20) to create a market. While this model was revolutionary, it had its limitations, particularly in terms of capital efficiency. The 50/50 liquidity provision requirement meant that capital was often underutilised, especially for pairs with significant price disparity.

In response to this, Uniswap V2 introduced several improvements, including the ability to create direct pairs between any two ERC-20 tokens, thereby improving capital efficiency. However, the most significant leap came with Uniswap V3, which introduced concentrated liquidity. This feature allows liquidity providers to specify price ranges for their liquidity, thereby maximising capital efficiency. Using this model, LPs can provide liquidity only at price levels where they anticipate trading activity, ensuring they are constantly making use of the liquidity in pools. This innovation has not only improved capital efficiency but reduced slippage, benefiting traders.

The evolution of Uniswap and the broader DeFi landscape underscores the critical role of liquidity management and capital efficiency in driving innovation. As the DeFi space continues to mature, the quest for improved liquidity and capital utilisation will undoubtedly continue to shape its trajectory. From the development of more sophisticated AMM models to the integration of cross-chain and layer 2 solutions, the pursuit of liquidity and capital efficiency will remain at the forefront of DeFi innovation. The role of liquidity in driving DeFi innovation is not only significant yet concurrently transformative, shaping the future of finance in profound and novel ways.

Taking the Next Step with Elektrik

Despite the progress made by protocols such as Uniswap V3, liquidity in web3 is still critically underutilised. While DeFi boasts a number of protocols that offer high levels of capital efficiency, the relatively small amount of liquidity present in the market often causes issues, particularly as it pertains to the cold start problem. At its core, the cold start problem refers to the challenge of launching a new product or service in a market where network effects are prevalent. In such markets, the value of the product or service increases with the number of users, creating a virtuous cycle of growth. However, this also means that when a product or service is first launched, it has little to no value as there are no users yet. Subsequently, at a fundamental level, the cold-start problem can be understood through a question – in an environment where users extract value from the existence of other users, why would the initial wave of users remain in the environment?

This problem is faced not only by newly minted protocols aiming to facilitate the liquidity of their own token, but also newly created DEXs looking to establish a base of liquidity providers for trading. Without this base, tokens would be untradable and the DEX would subsequently be rendered ineffective. Hence, the importance of implementing effective measures to foster the highest level of capital efficiency possible becomes clear, DEXs are seeking to overcome the cold-start problem with as little liquidity as possible whereby traders always face a positive experience.

Elektrik is one such DEX looking to solve this problem, implementing effective capital efficiency measures to facilitate high volume trading from its inception. Incidentally, this necessitates the adoption of novel and creative mechanisms to attract LPs and manipulate liquidity so that it is always available where needed. While traditional DEXs, such as Uniswap, have taken strides in this regard, Elektrik represents a new wave of DeFi protocols that can achieve more with less liquidity.

How Does Elektrik Work?

Elektrik is a DEX protocol built on the Lightlink Network. In its first iteration, Elektrik V1, the DEX plans to implement itself as a fork of the revolutionary Uniswap V3 architecture. As a fork of Uniswap V3, Elektrik carries forward the proven AMM model, enhancing it with the unique capabilities and features of the Lightlink network. This AMM model allows users to trade directly with the smart contract on the platform. Users can also become LPs by depositing assets into the liquidity pools and earn fees from the trading activity. This design is intended to provide efficient and flexible trading opportunities for all users. 

The protocol is built on Lightlink, a layer 2 blockchain secured by Ethereum, purposefully built for Metaverse, NFT, and Gaming applications. By harnessing the power of the Lightlink network, Elektrik is able to offer an efficient and seamless trading experience for its users. Most importantly, Lightlink offers a unique feature referred to as ‘enterprise mode’ which allows organisations to pay a monthly fee, covering its users’ gas costs, to simplify users’ experiences when transacting with ERC20 and ERC721 smart contracts, effectively bypassing native gas costs. This feature, combined with Lightlink’s low transaction fees and high speed, provides Elektrik with a significant advantage over other DEXs built on more traditional blockchains.

Elektrik’s design as a Uniswap V3 fork also brings with it a number of benefits. For instance, Elektrik, like Uniswap V3, provides higher capital efficiency compared to its predecessors by allowing liquidity providers to provide liquidity in concentrated price ranges, which, for sophisticated and active LPs, can potentially lead to higher returns. Furthermore, Elektrik supports single-sided liquidity provisioning, enabling LPs to deposit only one type of asset in a trading pair, reducing the risks associated with price fluctuations. 

In terms of fee structure, Elektrik implements an adaptive fee structure that dynamically adjusts fees based on market conditions and liquidity utilisation. This is achieved through the introduction of multiple fee tiers for each pair: 0.05%, 0.30%, and 1.00%. These options allow LPs to adjust their margins based on the expected volatility of the pair. For example, LPs can choose to take on more risk with non-correlated pairs like ETH/DAI, or minimal risk with correlated pairs like USDC/DAI, and select the fee tier that best compensates them for this risk. 

This ensures competitive fees for users while maintaining incentives for liquidity providers. By adapting fees to market conditions, Elektrik aims to promote efficient market participation and attract liquidity. Moreover, Elektrik introduces enhanced capital efficiency by utilising multiple fee tiers within liquidity pools. Liquidity providers can allocate their funds to different fee tiers, optimising their capital allocation and earning potential. This feature encourages efficient capital deployment and enables liquidity providers to maximise their returns.

Understanding Elektrik V2’s Liquidity Model

Although Elektrik is initially being released via the aforementioned Uniswap V3 model, Elektrik V2 plans to implement an innovative AMM. The Elektrik V2 platform represents a significant advancement in the realm of decentralised exchanges, distinguished by its incorporation of abstracted AMM, Artificial Intelligence (AI), Reinforced Learning (RL), and dynamic smart contracts. Central to Elektrik’s proposition is its commitment to capital efficiency, ensuring that liquidity is not merely present but is deployed judiciously for optimal trading outcomes. The Dynamic Liquidity Provision (DLP) mechanism is pivotal in this regard, meticulously adjusting liquidity with each block on the LightLink network to meet the precise requirements of liquidity providers.

While Elektrik V1 allows for LPs to add liquidity to particular price ranges, Elektrik V2 harnesses the power of AI to anticipate and modulate liquidity in the inherently unpredictable cryptocurrency market. While conventional AI models may falter in such volatile environments, Elektrik’s model is characterised by its dynamic adaptability. It undergoes continuous training on a diverse array of data, both internal to Elektrik and from external sources, ensuring its models remain contemporaneous and pertinent. This perpetual refinement is instrumental in ensuring that liquidity is judiciously allocated, responding adeptly to market fluctuations and safeguarding optimal trading conditions.

The decision-making prowess of this AI is further enhanced by the principles of Reinforcement Learning (RL). To elaborate, RL operates on a paradigm wherein the system discerns optimal actions through a process of iterative trial and error. Within Elektrik’s operational framework, RL assists in determining the most efficacious deployment of liquidity, harmonising the dual objectives of return maximisation and risk minimization. By synergizing dynamic AI with RL, Elektrik underscores its commitment to the judicious management of liquidity, thereby promising an unparalleled trading experience driven by precision and efficiency.

Comparing Elektrik to the Competition

Since 2021, the DEX landscape has been dominated by Uniswap V2-style DEXs, with many implementing the tried-and-tested x * y = k algorithm and spreading liquidity evenly across all price ranges. This can lead to inefficiencies, especially those associated with use of capital. If liquidity is dispersed across all price ranges, each pool will require a larger amount of liquidity to facilitate the same amount of volume. Consequently, more trading fees are dispersed to a greater number of parties and traders must be charged higher fees in order to provide LPs with the same level of yield. 

With the advent of Uniswap V3 in 2022, the DEX landscape has likewise undergone a subsequent evolution, with concentrated liquidity models becoming increasingly prevalent in DeFi. Nevertheless, these types of models often require manual rebalancing of liquidity or custom automated strategies by LPs, which can be relatively inefficient. Thus, even the relatively recent AMM models possess inherent flaws with regards to their management of idle liquidity that make them ineffective solutions when compared to next generation AMMs such as that implemented by Elektrik V2.

Elektrik V2 and similar DEXs will offer far greater flexibility than their contemporaries. The greater capital efficiency facilitated by the continuous rebalancing and concentration of liquidity will allow protocols to handle high volume trading with relatively insignificant liquidity. Thus trading fees for users can be reduced and those which are earned can be dispersed between fewer LPs, providing incentives for the participation of users and LPs alike.

Another key advantage of an automatic liquidity rebalancing model is the potential reduction in impermanent loss. Impermanent loss is a risk faced by LPs in traditional AMMs when the price of the assets in a pool diverges. By automatically adjusting liquidity to follow price movements, a DEX implementing this model can ensure that a LP’s liquidity is never concentrated in one side of a pool, mitigating the effects of impermanent loss. This means LPs are less likely to be holding the wrong asset when prices change, which can lead to more stable and predictable returns.

Notably, this model does possess some inherent challenges, particularly associated with the potential incorporation of machine learning for liquidity rebalancing. After all, if the AI makes an incorrect judgment, then the actual price range will have less liquidity than if the prediction were correct. However it is important to note that any particular price range would never be completely devoid of liquidity due to the use of a price weighting model by the AI, which allocates liquidity to certain price ranges depending on the likelihood that the price will be achieved. Furthermore, the learning curve for LPs in actually understanding and grasping this system may pose some challenges to adoption. Nevertheless, these challenges can be solved via frequent rebalancing and user interface abstraction for a more seamless user experience. 

Conclusion

The very definition of liquidity as the ability to quickly and effortlessly buy or sell assets, is the essence of a functional market, be it the financial markets at large or the intricate DeFi space. Its influence extends throughout history, where liquidity has ruled the dynamic and ever-evolving landscape of markets and as we have found, continues to influence the modern financial system – even in the context of DeFi. Therefore, it’s evident that DeFi markets, such as Elektrik, which foster liquidity and allocate it efficiently, are likely to remain at the forefront of their respective industries. Therefore, it’s evident that DeFi markets, such as Elektrik, which foster liquidity and allocate it efficiently, are likely to remain at the forefront of their respective industries. Consequently, as one of the principal determinants of market and asset success, liquidity, as championed by platforms such as Elektrik, will continue to drive innovation, incentivize adoption, and remain paramount in financial markets. 

Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.