Let's Talk Liquidity

In web3 liquidity is a measurement of how easy it is to get into and out of a token. People want their tokens to have high liquidity, so they can buy more or sell off their tokens easily. Of course most tokens start out by being earned and they hold value in their community by offering utility and rewards.

But eventually, people want to either increase their stake in the community or sell some of their tokens. This is done through one of two kinds of an exchange; either on a centralized exchange or a decentralized exchange.

The Traditional Method to Create Liquidity

Let’s first look at a centralized exchange. Some of the major centralized exchanges, or CEXs, are Coinbase, Kraken, and Binance. In these centralized exchanges you give custody of your tokens to the exchange, and then have permission to trade. The CEX has a list of all the prices for buying and selling the tokens and when a buy order and a sell order line up, they record the transaction.

This is a graph of all the offers to buy and sell a token. The little valley in the middle is the spread. Since both buyers and sellers want the best price (sellers want to sell high, buyers want to buy low) the spread is the gap between those desires. The more liquidity there is, the smaller the spread. 

In a centralized exchange liquidity comes from having a lot of buyers and sellers so that traders compete to take the lowest bid or highest ask. Because all the tokens are held by the exchange it means the cost of trading is usually low (nothing is recorded on the blockchain until tokens are taken out of the exchange).

Centralized exchanges typically only allow trading of the most popular and in demand tokens because they need a lot of trading volume cover their costs and they compete on price. So what happens when we want liquidity for a smaller social token?

There Has To Be a Better Way...

A decentralized exchange, or DEX, is a peer-to-peer trading system. With a DEX you aren’t handing your funds over to an exchange, but instead creating your own pool of liquidity or adding additional liquidity to a pre-existing pool, which is managed by a smart contract.

Let’s see what that looks like when you’re trading a token. If I want to spend $50 to buy $WHALE I can go to exchange.tryroll.com and see what a trade would cost in $USDC:

So $WHALE is worth $6.66, right? Not so fast… that price is based on how much $WHALE I’m buying, and in this case it’s just a little more than seven tokens. Let’s see what happens if I want to buy $500 worth of $WHALE:

See how the price of each $WHALE went up? Now each $WHALE is $6.88. What is going on here? 

Behind the scenes there is the smart contract. This contract is designed to balance the value of USDC and WHALE it holds. The more WHALE we buy, the less of it exists in the contract. And because there is less it is becoming a bit more valuable. Following the rules of supply and demand, as demand increases and supply decreases, the price goes up.

This is just like what happens on a CEX, but instead of needing thousands of traders this system can work with as little as one person providing liquidity. Of course, that would result in pretty low liquidity, meaning that the price would change a lot based on the volume of trading.

But a DEX allows others to join a liquidity pool, which puts more tokens into the pool, which then increases liquidity, which then helps to stabilize the price as the trades increase in size.

The Yin + Yang of Liquidity

Both centralized and decentralized exchanges work to provide liquidity. The CEX makes trading the most popular cryptocurrencies easier and cheaper, while the DEX allows anyone to provide liquidity for any combination of tokens and ensure liquidity for everyone. Both are essential to a healthy liquidity ecosystem. 

And liquidity is a major step for social tokens in becoming that valuable underlying structure of a community. It creates an on and off ramp for community members and enhances the underlying functionality of the token.

With liquidity you get price charts, trading volume, and the opportunity for token holders to directly support the community by joining the pool to provide liquidity for everyone. 

You can check out more social tokens that have liquidity on https://app.tryroll.com/markets.