Decentralized finance has long been hailed by the crypto industry as a superior alternative to traditional financial systems. Because of decentralization, the sector supports the development of more innovative applications, greater trust and control for users, and more accessibility, because no single entity has the ability to censor transactions or prevent someone from interacting with a protocol.
These benefits are significant, but that alone is not enough for the DeFi industry to achieve mainstream adoption as a real and viable challenger to TradFi. The industry is held back by a number of challenges, including its poor user experience and perceived security issues, but perhaps the most pressing problem is one that few actually understand – liquidity fragmentation.
Liquidity is vital for DeFi, because unlike centralized exchange platforms (CEXs) that hold vast amounts of crypto to enable their users to trade, decentralized exchange platforms (DEXs) instead rely on their users to provide the funds to enable trades. Users are incentivized to deposit their tokens into “liquidity pools” that provide the capital for others to trade, but this model has proven to be extremely inefficient. Because there are so many different DeFi protocols and blockchains, all competing for users to provide liquidity, a problem known in the industry as “liquidity fragmentation” has arisen.
Liquidity fragmentation casts a big shadow on DeFi’s potential. When liquidity is spread across hundreds of different protocols, it leads to issues such as high slippage – where users are forced to trade at unfavorable rates, and delayed transactions. This occurs because protocols simply don’t have the available liquidity to facilitate trades at the user’s desired price.
Why Is Liquidity Fragmentation A Problem?
Ran Hammer, vice president of business development at Orbs, spelled out the nature of the problem in an interview with Bitcoin.com, saying that although DEXs aim to provide users with the best possible rates, they’re unable to do so. “The landscape of on-chain liquidity is highly fragmented, spanning across various chains, multiple AMMs within each chain, and diverse pools within those AMMs,” he said.
According to Hammer, liquidity fragmentation has emerged as DeFi’s single-most pressing problem. “[It] has become the most significant hurdle, directly impacting users through unfavorable exchange rates and significant adverse price impacts on their swaps.”
It’s easy enough to see the problems fragmented liquidity causes. Simply visit any two DEX platforms, and you’ll likely see that they display different prices for the same asset, because each one is restricted by the available liquidity it can tap into. As such, their users may struggle to trade at the best price simply because they’re using a more inefficient platform.
For most users, it’s not easy to engage with multiple DeFi protocols to “shop around” for the best rates, because DeFi is highly complex at the best of times, and the asset prices themselves can change very quickly. Moreover, the need to trade assets across platforms results in higher transaction costs.
Unfortunately, what this means is that institutional users and so-called “whales” who have access to more sophisticated trading tools gain an unfair advantage, as they can perform swaps across multiple platforms in milliseconds and make substantial profits via arbitrage, which in turn, further impacts the prices offered to retail traders. So not only is life made difficult for regular users, but it also hinder’s DeFi’s core mission to democratize equitable access to financial services.
“DEXs are the cornerstone of any DeFi ecosystem,” Hammer said. “For a DEX to thrive and fulfill its purpose, it needs two key components: access to deep liquidity and competitive swap prices, and sustainable tokenomics.”
How Can Liquidity Fragmentation Be Solved?
The DeFi industry is aware of its liquidity problems and has been working hard to resolve them. One of the first solutions posed was the concept of the blockchain bridge, which makes it possible to trade tokens across chains via so-called “wrapped” versions of those assets. However, while these solutions, such as Wormhole and Multichain, do work, they have proven to be extremely vulnerable to hacks and bugs, as they introduce a single point of failure, which is the smart contract that facilitates these swaps.
Another solution is interoperability protocols such as Cosmos and Polkadot, which have built ecosystems of multiple, connected blockchains that can easily communicate with each other. However, these protocols still cannot talk to other blockchain networks, so they only offer a partial solution, and are held back by a lack of significant adoption.
More innovative solutions have emerged based on the concept of liquidity aggregation. For instance, Injex Finance is a DEX aggregator that aims to link together multiple DEX platforms and combine their available liquidity into a single pool for users to trade against. Orbs’ Liquidity Hub is based on a similar idea. It’s a Layer-3 infrastructure protocol that acts as a kind of optimization layer that sits above the AMM, tapping into external liquidity to minimize slippage and offer users the most advantageous rates found across numerous DEXs. It also taps into additional liquidity sources via on-chain solvers and other third-parties, such as financial institutions and market makers who wish to compete to facilitate trades.
Other takes on this idea include CrossCurve, which is a cross-chain DEX that aggregates liquidity for cross-chain tokens on networks such as Ethereum, Arbitrum, Optimism, Solana, Binance Smart Chain, Avalanche and Polygon.
Free-Flowing Liquidity Is On The Horizon
DeFi is a fast-moving industry known for its rapid pace of innovation, and the progress towards free-flowing liquidity will hopefully accelerate as more projects emerge to try and tackle liquidity fragmentation with greater efficiency.
By leveraging liquidity aggregation solutions, DeFi will develop a more efficient market structure and provide users with an overall experience that’s able to match CEX platforms in terms of control, pricing and speed. Providing this kind of experience will go some way towards making DeFi more palatable to users and overcome one of the major hurdles on the path to mainstream adoption.
