What changes has the rise of DeFi brought to Ethereum?

Liquidity is defined as the degree to which an asset can be quickly bought or sold in the market at a stable price that ultimately reflects the intrinsic value of the asset . The more liquid an asset is, the easier it is for the natural process of price discovery to occur, ultimately making the market more efficient.

Market depth decreases. Market depth refers to the sum of buys and sells on the order book and is directly related to the liquidity of the trading pair. Generally speaking, the greater the market depth, the more liquid the asset is and the easier it is to exchange assets at a stable price with minimal slippage.

We can observe that as ETH prices began to rise in late July, market depth dropped sharply, which is expected behavior during price fluctuations as market makers adjust their positions to increase risk . However, the sharp drop in market depth cannot be fully explained by price fluctuations, and may be related to the growth of ETH liquidity pools on decentralized exchanges, which may draw funds from centralized exchanges. At the same time, we also see a sharp increase in ETH transaction fees.

It is difficult to fully understand why ETH market depth has dropped so significantly since July, as there are likely multiple factors at play, including higher volatility, the growth of decentralized liquidity pools, higher transaction fees, and an overall increase in market risk due to continued economic uncertainty .

Spreads widen as volatility rises. Spreads are the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept. Generally speaking, the narrower the spread, the more liquid the market .

For most of the summer, ETH spreads narrowed as price volatility declined across all cryptocurrency markets. However, spreads began to widen in late July as ETH experienced a mini bull run. Market makers widen spreads to account for more risk in times of volatility. We can observe that spreads have remained volatile since July, corresponding to continued price movements triggered by events in the DeFi space .

Slippage remains low. Price slippage is closely related to market depth, measuring the difference between the expected price of a trade and the price level achieved after execution. High price slippage generally indicates a illiquid market. Following the market crash in March, price slippage on most ETH trading pairs was above average in May. However, slippage has remained relatively low since mid-June, with only a slight increase during the price volatility at the end of the summer.

Summarize

Liquidity is a particularly interesting topic right now given the growth of DeFi and automated market makers (AMMs), which enable a new and simpler way to provide liquidity for trading pairs . However, AMMs do not easily facilitate the price discovery process , as arbitrageurs must rely on centralized market venues to know when the price of an asset has changed. While there are several more efficient solutions for price discovery, risk management, and capital efficiency on DEXs, centralized order books are still the most efficient when it comes to determining the natural price of an asset through the interaction of buyers and sellers.