Defi 101 for Degens: Understanding Market Cap and Liquidity

Introduction

Have you ever wondered why A whale will sell 5 million $ worth of tokens off a 300 million market cap coin, and the market cap plummets to like 40 million $ instead of.... (300 - 5) 295 million $ market cap? Well, chances are the liquidity pool is slim and he ignorantly one-clipped. He probably even lost some of his bags to price impact and the remaining holders are now with a negative portfolio- ouch! A loss on both ends.

In this article, we’ll break down concepts like liquidity, price impact/slippage, and even Automated Market Makers (AMMs) — in fact, all the jargons that make the market cap of a token look like a lie because it certainly is. So, whether you’re a fresh-faced noob or a seasoned shitcoin connoisseur, I'm certain you'll pick one or two lessons from this article LFG!

What is Market Cap? (And Why Sometimes, it's a lie.)

First of all, The Basics;

Market cap = Current token price × Circulating supply.

So, if a token is trading at 0.1 price and it's got 1 billion circulating supply, when you do the math, the market cap is 100 million.

But here’s the catch: Market cap ≠ real-world value. It’s a metric of perception, not fundamentals. A token with a 600 million market cap tag just screams everybody's pnl in theory (unrealized) but when you want to realize your gains, it's a completely different story - that's when the almighty lIQUIDITY comes in.

Liquidity: The Secret Sauce of DeFi

What is Liquidity?

Liquidity is how easily you can buy/sell a token without moving its price. I want you to picture this; a swimming pool as wide as a football field with a depth of just 2 inches. What good is it to swim in it when you can't even make a successful dive without your head straight up hitting rock bottom? So then the size of the pool can be likened to the Marketcap as the depth of the pool is to the Liquidity. When the depth of the pool (liquidity) is slim, swimming (trading) becomes hard, something impossible despite the size of the pool (Marketcap) being large.

What is Price impact and how does liquidity affect it?

Price impact is the change in price of a token often when a large trade size is significant relative to the available liquidity. It goes both ways - either when buying or selling. So far your trade size will significantly affect the pool, you'll be getting the tokens at an expensive price, hence lesser amount of tokens or you'll be selling the tokens at a cheaper price, hence lesser value in return.

Note: People mostly confuse slippage for price impact but they're slightly different. Slippage is the difference between the expected price of a trade and the actual price at which it is executed. Slippage could be caused by several reasons like delay in trade execution, which could create room for volatility, being sandwiched by an MEV bot, or even price impact itself. But price impact on the other hand is just concerned with the ratio of your trade size with the available liquidity.

AMMs: The Magic Behind DeFi Liquidity

What’s an AMM?

Automated Market Makers (AMMs), first introduced in the likes of Uniswap & PancakeSwap, are the engines powering DeFi trading. Just as Centralized Finance (Cefi) makes use of an order book in which they gauge the number of buy orders (bids) with the number of sell orders (asks) to determine liquidity. Defi utilizes an AMM to determine liquidity.

The Formula is x * y = k

Where x and y are the amounts of tokens in the pool. While K is a constant.

Creating a realistic scenario should help us quite understand this AMM and how its formula is being utilized.

Practical Use case of an AMM

Okay, now visualize this. A token $sully under the Solana blockchain is being evaluated at a 20 million market cap while having a 1 billion total circulating supply. It has a total liquidity of $120k comprising of $60k worth of solana and $60k worth of $sully. I, as a trader, want to sell $40k worth of my $sully tokens at a go! Now, how much worth of solana would I get in exchange for my $sully tokens? What will be the price impact of my trade? The new market cap and possibly the new liquidity pool after my trade? Let's get to work.

First of all, if we're taking the price of Solana to be $250, then the amount of Solana tokens in the pool is 60000/250 which is 240

Also, the amount of $sully tokens in the pool will be 60000/0.02(price of $sully) = 3,000,000 and the amount of sully I am to exchange is 40,000/0.02 = 2,000,000

using the formula x(Solana)* y(sully)= k

240 * 3,000,000 = 720,000,000 (the constant)

After my trade, the pool reserves will be 3,000,000 + 2,000,000 = 5,000,000 sully tokens.

and since the AMM must satisfy this; X Y = k X 5,000,000 = 720,000,000 X = 720,000,000/5,000,000 = 144 Solana tokens. (which has dropped from the initial 240 in the pool)

240 - 144 = 96. That's the amount of Solana I got, which is worth $24k. You see, I exchanged $40k worth of $sully for $24k worth of sol. I lost the rest to price impact.

To calculate the percentage of price impact caused by my trade:

$40k is my intended value but $24k is my realized value. (40k - 24k)/40k = 0.4 = 40% price impact.

To calculate the new market-cap, we'll need to calculate the new price of $sully in the pool. Since the value of Solana in the pool has to equate to the value of $sully in the pool, hence we have -

144 * 250 (value of sol) / 5,000,000 ($sully amount in pool) = 0.0072 (price of sully in pool)

marketcap = 0.0072 * 1 billion (circulating supply) = 7,200,000 mcap.

Since the value of sol in the liquidity pool is 144 * 250 = $36,000, the value of $sully in the pool is also $36,000. Together makes it $72,000 (that's a massive drawdown from the initial $120,000!)

Conclusion

If you try the math for all the variables I've solved above in the same scenario but with a better liquidity pool; let's say $2,000,000, you'll get a better value for the exchanged tokens, a much more lesser price impact and a better market cap after trade. So next time you want to ape that token, look at the market cap to liquidity ratio and ask yourself, "Can I actually exit this trade?"

Till we meet again anon. GG.