Introduction to DeFi Liquidity risk

Economics Design

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One major category of risk exposures for the defi industry is liquidity risk. In traditional finance, liquidity risk often refers to the uncertainty in a business’s ability to cash out assets. In defi, we define the term liquidity risk differently as risks associated with the primary market.

The liquidity risk can be seen as a composite of systematic and idiosyncratic risk, as it can be significantly affected by market and user activities. However, it can also be managed and controlled by the protocol to some extent. This includes changes in liquidity between tokens and other assets (including other tokens and the fiat currency), and uncertainties from depth of liquidity pools. Depending on the type of defi, such uncertainties may result in unwanted variations of token prices, overly high transaction costs and limitations in executing trades. In this article, we will discuss what liquidity risks are, how they can arise from multiple areas and their impact on defi protocols in the long term.

Lending and borrowing type of DeFi

For defi providing lending and borrowing services, users take up loans in forms of tokens of a particular defi upon depositing other assets as collaterals. For this type of defi, liquidity risk mainly lies within changes in liquidity between the token used for loan distribution and different assets, which may inherently affect market price and demand of the token. In situations where the loaned token faces unexpected regulations and restrictions in usage, liquidity of the token is likely to decrease with the reduced use cases. This triggers a decrease in the token’s demand and market price, which would affect operation of the defi in the long term.

Meanwhile, liquidity risk can also arise from the underlying assets of these tokens. During market downturns where asset prices generally experience large falls within a short timespan, liquidity of assets at each price level is likely to decrease as there is less demand for the asset. If demand is not being restored in time, it would potentially exert even more downward pressure on price as people are eager to move out of their positions. This would cause the total value of collateral assets deposited in these defi to decrease as well. In the more severe cases where value of collaterals falls below the minimum required rate to keep accounts active, forced liquidation would be triggered.

In addition, for defi that issue loans in forms of stablecoins upon collection of other assets as collaterals, there is also the common problem of liquidity mismatch, where liquidity of the token’s held assets and liabilities are different. During the token redemption process, users are expected to pay back loans and borrowing fees to get back assets deposited previously. However, given the high price volatility of these assets, their liquidity may have changed during the period of borrowing. This forms a risk for the defi protocol, as it needs to ensure the ability to return these assets. This type of liquidity risk is usually difficult to mitigate, as liquidity between cash and assets are affected by many factors that are out of the protocol’s control, and the digital asset collaterals deposited are usually only saved with no active management.

Trading type of DeFi

For defi providing trading services like decentralised exchanges (DEX), liquidity is a major source of risk as it directly affects the ability of these platforms to carry out trades between different asset pairs and the demand for such transactions.

Most of the decentralised exchanges today use automated market makers (AMM) to execute transactions for its ability to enable instant liquidity and flexibility in allowing new pairs of trading. Liquidity providers deposit assets into the defi’s liquidity pools in return for rewards, and the assets deposited will subsequently be used to allow trades with other assets on the platform. While the detailed mechanism varies among different defi providers, the AMM algorithm generally determines price of a transaction by proportion of assets in the liquidity pool. Asset with greater proportion in the pool after transaction will have lower price, and asset with smaller proportion will be more expensive vice versa. This allows prices of each asset to be balanced with real time liquidity.

With the high degree of reliance on liquidity pools to determine prices, which directly affects the demand for transaction services, it is especially important for decentralised exchanges to properly manage their liquidity pools. In the ideal scenario, a liquidity pool should have a large total value, and a balanced proportion of each asset according to market demand. This can be influenced by how the defi protocol designs the reward to liquidity providers.

Some of the potential ways to attract more people in contributing to liquidity include higher reward rate, extra credits if assets are deposited for a long period of time, and distribution of earnings from transaction fees to liquidity providers. Meanwhile, the reward rate should not be excessively high to prevent inflation of the defi token. In cases where the defi is unable to provide attractive reward for these liquidity providers, the liquidity pool is likely to hold less value. This would make prices of assets to be more volatile as they are prone to price impact caused by large transactions, and also higher transaction fees in executing the trade. These would discourage people from making orders for trades, affecting transaction income for the platform and further causing liquidity providers to withdraw their assets. In the long run, the defi’s operation and financial health will be negatively affected.

Suggestions on measuring liquidity risk

With the complexity and numerous sources of liquidity risk, there is no single metric that quantifies the level of liquidity risk exposures faced by a defi. Instead, we can break down the problem by listing down factors that could possibly affect liquidity risk, and compare the level of risk exposures from there.

For liquidity risk associated with market demand, some potential indicators of high level of liquidity risk exposures are decreasing price accompanied with decreasing daily transaction volume of token, decreasing amount of token in circulation, and significantly more sell than buy orders at each price level for a prolonged period of time. These hint a decreasing demand for the token in the primary market, which may result in lower liquidity.

For liquidity risk from the liquidity pools, some possible metrics are the total value of assets stored in the pools, the proportion of various assets in the pool, and growth in quantity of each type of tokens held. In addition, we can look out for trends in the changes of price slippage for the commonly traded pairs, where a higher price slippage for the same transaction over time hints that the components of liquidity pool is less balanced than before, and liquidity risk is higher.

Conclusion

The idea of liquidity risk is very different from liquidity risk in traditional finance. Yet the unique mechanisms used by defi protocols to provide financial services and high degree of influence from the primary market in the industry have made it a very important source of risk. While the lack of commonly accepted metrics to measure such risks makes it difficult to assess risk levels and make comparisons, defi users and providers should still be aware of the potential impact of liquidity risk to make well-thought decisions in the long term.