The world of cryptocurrencies is constantly evolving, and shared liquidity is one of the most significant developments to emerge in recent years.
Shared liquidity allows traders to access a larger pool of liquidity by connecting various exchanges (centralized and decentralized) and trading platforms. It can potentially reduce market volatility, improve price discovery, and provide traders with better pricing options.
What Is a Liquidity Pool?
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Liquidity is a crucial aspect of financial markets, including Web3. It refers to quickly and efficiently converting one type of asset into another type without causing significant price fluctuations.
On the other hand, illiquid assets cause price slippage, where the actual selling price is lower than the intended price.
Think of a fast-food restaurant with several cashiers to take orders. It speeds up the transaction process, making customers happy. In contrast, a restaurant with only one cashier and a long queue of customers creates a slow and frustrating experience.
In traditional finance, buyers, and sellers of an asset provide liquidity. However, in DeFi, liquidity pools provide liquidity, enabling the system to function smoothly.
Essentially, a liquidity pool is a virtual pool of cryptocurrency assets held within a smart contract.
What Is Shared Liquidity?
Shared liquidity refers to combining liquidity pools from multiple sources to create a larger and more interconnected pool of assets. It can occur between different platforms, protocols, or exchanges.
By sharing liquidity, participants can increase access to a larger pool of assets, leading to improved market efficiency, more significant trading volumes, and increased price stability.
Undoubtedly, shared liquidity is particularly critical in the decentralized finance (DeFi) ecosystem, where interoperability between different platforms and protocols is crucial to creating a seamless and efficient user experience. After the evolution of legendary concentrated liquidity by Uniswap V3, shared liquidity is the next big thing!
Let’s take a deeper look.
1. Access to Greater Trading Volumes
One of the most significant benefits of shared liquidity is access to more substantial trading volumes.
In traditional markets, traders are limited to the liquidity available on a single exchange. It can be a significant drawback, especially in times of high volatility when liquidity can dry up quickly.
However, with shared liquidity, traders can access a more extensive pool of liquidity, increasing the chances of executing their trades at the desired price.
This increased volume can also lead to lower transaction fees. More on it later.
Also, traders can take advantage of a more competitive market and access a broader range of pricing options. It can lead to lower transaction fees, which can significantly increase over time, especially for high-volume traders.
2. Improved Market Efficiency
Shared liquidity not only offers access to larger trading volumes, but it can also enhance market efficiency. By connecting multiple exchanges, traders can access a broader range of pricing options, leading to tighter spreads and better pricing. It also gives rise to arbitrage opportunities, which propels sustainable pricing mechanisms. This can bring prices on different exchanges closer, leading to better price discovery and tighter spreads overall.
For instance, if one exchange has a higher ask price for a particular token, traders can use shared liquidity to purchase the token at the lower ask price and then sell it on the higher-priced exchange.
Moreover, shared liquidity can foster increased competition among exchanges. More competition brings better innovation, period.
Shared Liquidity In Action
Decentralized exchanges (DEXs) are one example of shared liquidity in action. DEXs are peer-to-peer marketplaces where traders can buy and sell cryptocurrencies without a central authority- instead, a smart contract facilitates the trades, ensuring all parties receive their fair share of the transaction.
DEX aggregators typically rely on shared liquidity, allowing traders to access a more extensive pool of liquidity than they would on a single exchange.
Another beneficiary of shared liquidity is Cross-Chain Bridges. Cross-chain bridges allow for shared liquidity between blockchain networks. That implies the liquidity shall not be fragmented in any way. Instead, it can be cross-chain, cross-platform, and universally accessible.
Besides, Stablecoin Pools use shared liquidity pools to maintain price stability. By pooling resources, stablecoins can maintain their peg to the assets like US dollar and provide a reliable source of liquidity for users.
Many Protocols, Same Pool, Different Purposes
The novel idea of shared liquidity is when several protocols use the same liquidity pool for different purposes. One user might be bridging; another might be trading or even collateralizing. They can all use the same pool, irrespective of their platforms and networks.
For example, a liquidity pool may be leveraged to provide liquidity for decentralized exchanges, lending platforms, prediction markets, and more.
This approach can be beneficial for several reasons.
Firstly, it can help increase the liquidity available in the pool, as multiple protocols contribute to it. It can be conducive for more minor protocols struggling to attract liquidity. Low TVL (Total Value Locked) is the primary reason for the failure of many defi protocols. As you know, TVL attracts even more TVL, as volume attracts even more volume. These both attract users, and users bring all the more volume. This is why videos with the most views get even more views or apps with the most downloads get more downloads.
Secondly, it can lead to increased interoperability between different protocols.
If multiple protocols use a liquidity pool, users can move their assets between these protocols without needing to leave the liquidity pool. It can lead to a more seamless and integrated user experience and help increase the adoption of different protocols. At a point, the pool becomes omnipresent and multi-asset supporting.
However, there are also potential risks associated with this approach.
Suppose a particular protocol experiences a significant drop in demand. In that case, it may withdraw its liquidity from the shared pool, potentially impacting the liquidity of other protocols that rely on it.
Additionally, there is the risk of smart contract bugs or vulnerabilities that could lead to losing funds for all pool users.
Challenges of Shared Liquidity
While shared liquidity offers many potential benefits for traders and the crypto industry, several challenges must be addressed.
- Increased systemic risk due to the potential impact of failures or hacks of one platform on other platforms that are sharing liquidity
- Potential for increased regulatory scrutiny and restrictions as shared liquidity becomes more widespread and interconnected
- Ensuring security and privacy for users becomes more challenging as more exchanges and protocols use shared liquidity.
- Need for platforms to implement robust security measures to prevent hacks and protect user privacy.
By increasing access to liquidity, improving market efficiency, and promoting interoperability, shared liquidity has the potential to help the industry reach new heights.
However, it’s essential for platforms to bring innovation to address the challenges and work together to ensure a secure and efficient ecosystem for all users.
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