Blurb on Liquidity: Understanding DeFi Market Dynamics

Liquidity refers to how easily and efficiently a market can execute trades with minimal price changes. A liquid market allows quick transactions without significant impact on price.

Key Metrics of Liquidity

Spread - Difference between highest bid and lowest ask; affects small trade costs.
Depth - Amount of capital available at various price levels; stabilizes large trades.
Price Impact - Deviation from expected cost due to trade size and market conditions.
Slippage - Unexpected price changes between order placement and execution.

Key players in the liquidity management are Market Makers (MMs) and Automated Market Makers (AMMs)

Market Makers

Provide liquidity by posting buy/sell orders.
Profit from spreads but compete by offering tighter quotes and deeper liquidity.
In order-book markets, they actively manage quotes; in AMMs, they deploy capital.

Automated Market Makers

Use algorithms to set prices and distribute liquidity.
Earn fees but face impermanent loss—the opportunity cost of not holding assets directly.

Why Liquidity Matters?

Liquidity ensures efficient price discovery and prevents liquidation spirals in loan markets. Liquidity also supports capital-efficient trading and lending and enables robust DeFi infrastructure and user trust.