Liquidity Wars: The Evolution of DEX Design in a Competitive Landscape

It sounds like a Star Wars saga, but Liquidity Wars is no mere fantasy. Rather than taking place a long time ago in a galaxy far, far away, it’s a battle for supremacy that’s being fought onchain as you read these words. There’s a fight underway to land a decisive blow in the DEX wars – and the victor will be the platform that can muster the most liquidity.

On a Crypto Network Right Now

There’s a lot of blockchains out there and an even greater number of DEXs deployed on them. Since we’re conjuring galactic imagery, these chains are planets and the DEXs are moons caught in their orbit. Each of these decentralized exchanges is fighting for market share: users; fees; attention; and of course liquidity. All of these things are finite, since DeFi’s existing user base can only be split so many ways.

It stands to reason that when one DEX becomes popular, it’s at the expense of other exchanges, which must lose out. This is merely a consequence of market economies and is as healthy as it is normal. DEXs operating in this innovate-or-die environment must distinguish themselves from the many other moons out there. If they’re to attract more users than rival DEXs, including those operating on both their native chain and other farflung networks, they need to excel in the following domains : UX, product, and liquidity.

UX is obvious: if a DEX looks better and is easier to use than anything else on the market, users will naturally be drawn to it. Product simply describes the platform’s ability to offer novel features that there’s a demand for and that rival DEXs can’t easily imitate. And liquidity is, well, liquidity. The more of it you can procure, the greater the trading experience will be, especially for whales and institutions swapping with size.

And it’s liquidity that has become the frontline in the battle for DEX supremacy that’s forever raging across the omnichain universe. Enhancing UX and product is hard, and delivers diminishing returns after a while. You can only improve user experience so much or add so many features. But liquidity, why, liquidity is virtually limitless if you know where to look. Procuring it yourself for the sole purpose of filling up your DEX liquidity pools doesn’t come cheap. But if you can enlist a specialist to do the work for you, liquidity is in plentiful supply. As the following examples show, there’s more than one way to solve this challenge.

Concentrated Liquidity Courtesy of Uniswap

Uniswap has transformed DeFi on multiple occasions, with each new version of its AMM upping the ante and spawning a slew of imitators. V3 was particularly significant, introducing a genuinely revolutionary feature in the form of concentrated liquidity. This allows liquidity providers to allocate their capital within specific price ranges rather than spreading it across the entire price curve, as was the case with V2. Rather than requiring more liquidity to be pooled, V3 simply engineered a way to use existing liquidity much more efficiently.

For example, in a stablecoin pair like DAI/USDC, where trading typically occurs within a narrow price range (e.g. $0.99 to $1.01), LPs can concentrate their liquidity between these price points to maximize fee earnings. Through focusing capital where trading volume is highest, LPs can earn more than 3x in fees compared to traditional AMMs – though this does require active management to adjust the range in volatile markets. Uniswap V3 has proven invaluable at deepening available liquidity, particularly for relatively stable pairs such as ETH/USDC and has become a firm favorite among professional LPs.

Curve’s Vote-Escrow Model

Curve Finance’s much emulated and iterated vote-escrow (ve) model is designed to incentivize long-term commitment and optimize liquidity allocation. Users lock their CRV tokens in a vote-escrow contract to receive veCRV, a non-transferable token that grants governance rights and decays linearly over time. The longer the lock period, the more veCRV and voting power a user receives initially. This model has proven adept at aligning user incentives with the protocol’s long-term success, as veCRV holders can vote to direct liquidity incentives to specific pools.

Under the ve model pioneered by Curve, for instance, locking 1,000 CRV for four years provides the same initial voting power as 4,000 CRV locked for one year. This system has been successful in deepening liquidity in Curve’s pools, particularly for stablecoin and low-volatility pairs, though the obvious downside is that it requires users to forgo liquidity during the lock-up period. Nevertheless, its success has caused many other projects to adopt a similar mechanism, such as Frax Finance with FXS.

Velodrome’s ve(3,3) Mechanism

Velodrome Finance, built on Optimism, combines Curve’s vote-escrow model with Olympus DAO’s (3,3) game theory to create the ve(3,3) mechanism. Users lock VELO tokens to receive veVELO, which grants governance rights and the ability to vote on liquidity pool incentives. The (3,3) model, inspired by Olympus DAO, encourages long-term holding: when users lock tokens instead of selling, everyone benefits through increased rewards and deeper liquidity.

Unlike traditional AMMs where swap fees primarily go to LPs, Velodrome distributes fees to veVELO holders who vote for specific pools, while LPs receive emission rewards. This dynamic allocation ensures that the most active pools receive the most liquidity, though this system can be complex for new users to wrap their heads around due to the need for active voting and strategic locking.

THENA’s Orbs Integration for Unlimited Liquidity

THENA, one of the leading BNB Chain DEXs, has taken a very different approach to solving the liquidity challenge. Rather than attempt to engineer a proprietary solution, or rework a model such as that popularized by Uniswap or Curve, it’s cast its gaze to Layer 3, where it’s found a willing partner in the form of Orbs. The latter’s Liquidity Hub has been neatly integrated into THENA’s DEX along with Orbs’ popular dLIMIT and dTWAP protocols.

Orbs’ Liquidity Hub aggregates liquidity from both on- and off-chain sources, allowing projects such as THENA to tap into virtually unlimited liquidity. This means that a DEX isn’t just constrained by available liquidity sources on its own chain: it can now access it from across the crypto landscape. Not only is this an effective means of deepening DEX liquidity without needing to invest in costly LP incentive programs, but Orbs’ solution can be seamlessly integrated without changing user experience. From the perspective of THENA users, everything looks and feels the same as usual, but with better pricing and lower slippage now that Liquidity Hub’s taking the strain. 

DeFi’s Liquidity Wars Rage On

Despite DEXs being in competition with one another – and with centralized exchanges too – their onchain liquidity war doesn’t have to be a zero-sum game. For one DEX to prosper, it isn’t necessary for another platform to wither and die. There is enough liquidity out there for multiple DEXs to thrive on every major blockchain. It’s just that right now, it’s not evenly distributed.

The DEXs that survive in an adversarial onchain landscape will be the ones that deploy smart strategies to gain the liquidity their users crave. Whether engineering their own tokenomic incentive model or procuring liquidity from specialist L3s, viable solutions are available. As DeFi matures, the most successful decentralized exchanges will be those that balance user experience and innovative features with powerful liquidity solutions. The DEXs that master these three forces will dominate the industry for years to come.