Introduction
In our journey to understand how liquidity was set out to work in the Polkamarkets Protocol, let's start with a few basic facts:
- In order for users to be able to buy/sell outcome shares, markets are required to have liquidity.
- Market Creators must add liquidity to any market that they create.
- Any market participant can add or remove liquidity to a market, at any moment, until the market expires.
- Participants that contribute with liquidity to a market are known as Liquidity Providers.
- Liquidity Providers can earn rewards up to 5% of every buy and sell transaction that happens on that market, depending on the Liquidity Providers Fee set out by the Market Creator.
- The rewards received by each Liquidity Provider are proportional to the number of liquidity shares that they hold on the Liquidity Pool (i.e.. the total share of the Liquidity Pool that such Liquidity Provider represent).
The importance of Liquidity
Polkamarkets is autonomous and uses an Autonomous Market Making (AMM) algorithm to ensure that trades are covered, similar to how decentralized exchanges like Uniswap work.
The Liquidity Pool of each market therefore ensures that trades can be covered. In practice, participants in Polkamarkets trade against the Liquidity Pool. To compensate for this risk, Liquidity Providers can be rewarded with a percentage of each trade (the Liquidity Providers Fee), and receive further incentives for providing liquidity to prediction markets (see below).
Markets with a high amount of liquidity ensure a smaller price impact when forecasters buy or sell large amounts of outcome tokens. Given that the price of the outcomes represents the likelihood of that outcome happening, the more liquid the market is, the finer grained its prices will be.
Therefore, a highly liquid market provides the ideal conditions for accurate forecasting.
That being said, Market Liquidity is an advanced topic and adding liquidity exposes you to a risk of loss. You should read the articles provided in this section carefully before providing liquidity to any market.