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Liquidity is often swept under the rug, and many people devalue the importance of it. At a high level, liquidity facilitates markets, allowing users to trade between two tokens. This is often seen in DeFi in AMMs (automatic market markers).
To incentivize liquidity, protocols reward those who do with their native token. As providers are exposed to impermanent loss (occurs on token price appreciation and depreciation), the hopes is that these rewards offset the losses. However, this provides yet another set of issues:
- 1.Temporary liquidity: The liquidity is mercenary, once the rewards leave, so does the liquidity. You've provided liquidity for the short term, but is not a permanent nor feasible solution.
- 2.Lack of security: The liquidity is owned by users and not by the protocol, they are free to exit at any time. This means during times of turmoil, liquidity providers will leave in order not to suffer impermanent loss, when the protocol needs it the most.
- 3.Constant selling pressure: Since rewards are paid to the LP, they sell these rewards either to LP more, causing more emissions, or to another asset ,causing constant selling pressure to the token. (source: Klima)