Basically, liquidity is how much of a specific asset is available, when, and at what price. It dictates how prices evolve relatively to demand.

In CeFi, this liquidity is available on exchanges’ orderbooks. The more liquidity, the deeper the order book, and the easier it is to execute trades without moving the price.

In DeFi, AMMs are orderbooks’ equivalents.

AMMs like Uniswap or Curve have different “liquidity mechanisms”.

For example, Uniswap V3 allows to put liquidity at very specific prices, like on orderbooks, while Curve puts a similar amount of liquidity everywhere.

You can check agEUR liquidity in the 3EUR Curve pool here: https://dune.com/queries/726358.

Ultimately, liquidity is what allows people to buy or sell assets at the best market price, 1 EUR for agEUR for example.

Unfortunately, liquidity can vanish very quickly. When it does, prices become more volatile, increasing instability.

This can cause a lot of troubles, especially for key DeFi protocols which designs rely in one way or another on liquidity.

Out of these protocols, the ones relying the most on liquidity outside of AMMs are probably stablecoins and lending markets.

All stablecoins rely on liquidity to maintain their peg, whether through arbitrages or liquidations.

For example, arbitrageurs maintain agEUR price to 1€ by buying and selling tokens on different pools.

To do that, they need liquidity themselves, and liquidity available in the pools they use for arbitrage.

One aspect of Angle is that its Core module provides “infinite” liquidity on the buy side, facilitating arbitrages.

Anyone can buy any amount of agEUR from the protocol with very limited slippage.

UST depeg example

An interesting case study is the recent collapse of UST.

Before its fall, one of the main source of liquidity for UST on-chain was the UST-3pool (DAI/USDC/USDT) on Curve.

A few hours before UST price started depegging, ~50% of the 3pool tokens were withdrawn from the pool.

This reduction in available liquidity effectively meant that fewer LPs were willing to provide 3pool tokens in exchange for UST.

This prevented anyone from selling big amounts of UST at the theoretical price of $1.

Sellers were forced to use the LUNA redemption mechanism, which had a big impact on LUNA price and quickly initiated the death spiral once it was clear for everyone that the system couldn’t hold.

Stablecoins like agEUR or DAI, and lending markets like Aave or Euler, also rely on liquidity for liquidations.

As liquidators need to sell the collateral asset immediately to realize their profit, they have an important impact on the market.

If there is too much slippage, liquidations become unprofitable and bad debt is stuck into the system.

To learn more about liquidations, and how this market impact could be reduced, you can read our Angle Explains Liquidations thread 👉

Even if liquidations were profitable, insufficient liquidity could kill the asset price. This is what happened recently with Solend, where liquidating a single whale position with SOL collateral would have dropped its on-chain price 46%. https://twitter.com/solendprotocol/status/1538553654575214592

A more recent and popular DeFi product relies heavily on liquidity, as their name suggests: liquid lockers.

Basically they are protocols offering liquid versions of veTokens, that can be bought and sold for the underlyings.

If you want to learn more about liquid lockers, you can go through our Angle Explains Liquid Lockers first here 👉 https://twitter.com/AngleProtocol/status/1533416014033059841

The catch is that though these tokens can effectively be bought or sold, liquidity is still fairly limited.

Again here, if everyone was looking to sell at the same time, these tokens would likely face liquidity issues.

At this point, it should be clear that liquidity is a cornestone of DeFi (and any transactional activity really), and there is usually never enough of it when needed.

So how can we make liquidity stick?

The first incentive was trading fees, but it quickly appeared that it wasn’t enough. Then came liquidity mining, distributing governance tokens as additional rewards to keep liquidity in the pools.

However, everyone started doing it, which made available liquidity even more mercenary. LPs are now jumping from feast to feast looking for the juiciest one.

It also puts pressure on the tokens price as LPs sell their loot for an instant profit.

The goal now should be to find better incentives and trade-offs for liquidity providers to make sure their liquidity stays in the system, where it is most needed.

A potential improvement that is appearing are LP management services, like Gamma or Arrakis.

By actively managing positions, they can generate more returns for LPs offering them more incentives to leave their liquidity on the table.

However, they will likely still have to look for the best risk/rewards opportunities and move between pools to offer the best returns to their clients, not solving the core issue.

So how can we prevent liquidity to be withdrawn and to disappear? What if it could be locked?

We are already seeing that with protocol-owned-liquidity (POL), Frax incentives program, or Balancer veToken model.

Going further, we can imagine an AMM wrapper letting users lock funds for a specific time to be provided as liquidity.

Fees would be redistributed proportionately to lock time, effectively creating some sort of on-chain liquidity bonds.

The benefits would be to have 1) liquidity locked for a pre-determined amount of time, and 2) a way to price the time value of tokens on-chain.

At Angle, we want agEUR to be part of this liquidity infrastructure, which is why we are thinking about ways to improve it.

Finding better alternatives to make the market more robust in difficult times is very important for the whole space.

Thankfully, DeFi primitives are allowing new mechanisms and use cases that weren’t possible with traditional finance.