The market volatility and drastic price changes in cryptocurrency led to important conversations around liquidity and liquidation. If an asset is illiquid, it takes time to convert it to cash and the market changes may cause its price to be unfavourable at the time of eventual cash-out. When an asset’s value changes drastically against a trader’s position, the trader may get liquidated. Despite having similar parlance, these terms have distinct use cases and implications. In this article, we provide an in-depth overview of the meaning of each term and their implications in the Web3 space.

Key takeaways

Liquidation in cryptocurrency refers to a situation where a trading position closes because the trader has insufficient funds to keep their leverage active.
Liquidity indicates the speed of transacting with an asset and is achievable through the utilization of liquidity pools
Automated market makers are protocols that utilize liquidity pools to allow transactions to be completed automatically without any need for traditional buyers and sellers
The crypto world has been engulfed by systemic crises caused by insolvency issues which later exacerbated into liquidity crises

Liquidation

In general financial terms, liquidation simply means selling assets for cash. When you’re liquid, in commonplace terminology, you have accessible and moveable cash. On the contrary, liquidation in the cryptocurrency landscape means more of a nightmare. It refers to a situation where a trading position closes because the trader has insufficient funds to keep their leverage active.

Types of liquidation

Partial liquidation involves the trader cashing out of his stake to prevent further loss of the entire initial margin while total liquidation involves total loss of the initial margin because the asset has unbearably moved against the leveraging position. Total liquidation is usually forced.

Voluntary liquidation happens when the trader decides to cash out from a losing trade or for other reasons best known to them, while forced liquidation occurs when the crypto exchange closes the trader’s position to prevent further losses.

Liquidity

Unlike liquidation which refers to the loss of assets, liquidity is the ease of converting assets to cash. Liquidity is a fundamental part of financial and crypto markets and it indicates the speed of utilizing an asset. An illiquid asset will take long periods to be converted to cash, an unfavourable experience, especially in crypto markets. Any trader in traditional or crypto markets can attest to the disadvantages of entering any market without enough liquidity. This is because illiquidity may cause slippage, which is the disparity between the eventual selling price of an asset and the price at which the sale was initiated.

To aid further understanding, we can compare liquidity to the ease of purchasing an item in a convenience store. When you get to the store and there are enough attendants to process your payment, you collect your purchase almost immediately with ease. However, if there is just one attendant, you’ll have to queue for long, leading to a frustrating experience.

The same scenario applied to the crypto world till the creation of liquidity pools. Before the creation, crypto market liquidity was a challenge on decentralized cryptocurrency exchange platforms (DEXs). This is because DEXs were new, the interfaces were complicated and just a few users were onboarded, leading to few numbers of regular traders. People were not incentivised to commit to the platforms and illiquidity was a big challenge. Automated market makers (AMMs) fixed this problem of limited liquidity by allowing the existence of liquidity pools and incentivising the liquidity providers without a need for third-party processors. This was a big win for the DEX and the Web3 industry, signifying a spike in the mass adoption and ergonomics of decentralized crypto markets.

Liquidity pools

Simply put, liquidity pools aggregate assets to allow easier trading and buy/sell transactions. It is a stack of cryptocurrencies locked in a smart contract allowing for faster transactions. The discussion of the liquid pool cannot be complete without mentioning the enabler of the technology known as automated market makers (AMMs). These are protocols that utilize liquidity pools to allow automatic transaction completion without any need for traditional buyers and sellers.

Liquidity pools are aggregated by liquidity providers (LPs) and were designed to incentivise them. LPs lock assets inside liquidity pools for a certain amount of time and they are rewarded based on the equivalent amount of liquidity supplied. This reward, which comes in LP tokens, can be through earning a fraction of trading fees generated via transactions on the liquidity pool or other platform incentives.

Without liquidity pools, DEX platforms cannot function. This is because users who want to convert their assets have to wait for prolonged periods, risking slippage amidst the ever-volatile crypto market. This means traders may encounter a difference between the executed price and the expected price. Common DEX platforms that use liquidity pools include Uniswap, SushiSwap, and PancakeSwap.

Relationship between liquidity crises and insolvency

Another interstice that needs to be filled in the bid to understand liquidity within the context of cryptocurrency is the relationship between liquidity crises and insolvency. Many crypto companies have been affected by liquidity crises, forcing them to restrict access of users to stored funds. The main reason for this scenario is not usually illiquidity but a broader solvency problem.

If a business is solvent and has ample amounts of valuable assets, it can navigate any liquidity crisis. Illiquidity to this company will mean some users are suddenly withdrawing large funds at the same time, usually more than the company’s available cash capacity. Such a business will be able to navigate this situation by selling or liquidating assets or getting loans because of its good credit score.

Companies like FTX, BlockFi, Voyager Digital, and Celsius Network have ended up in bankruptcy courts because they are insolvent. These companies experience liquidity crises because of fundamental issues related to funds mismanagement and over-reliance on a large pile of claims. Their balance sheets are filled with intangible assets and large amounts of company-owned tokens that indicate insolvency, leading to liquidity crises. This indicates that for any firm to crumble because of liquidity crises, it must have gone through a process of insolvency and not vice versa.

Conclusion

Liquidity and liquidation are important terms crypto enthusiasts must be familiar with. While both apply to Web3 because of the volatile nature of cryptocurrencies, they have distinct use cases. Liquidation depicts the instance of asset loss due to market changes while liquidity indicates the ability to easily move and convert assets. In the early phase of DeFi, DEXs suffered liquidity problems because they were modelling traditional financial systems. However, liquidity pools helped address this problem and soon became instrumental in unlocking growth in the DeFi space. Crypto companies should prioritize survival by ensuring that their processes are not insolvent and they are constantly innovating to keep liquidity at acceptable levels.