DeFi lovers know all too effectively the advantages that decentralization can carry to finance: trustless operations, innovation and better management for customers.
But, as with all transformational shift, rising pains are inevitable. Amongst these, fragmentation, significantly when it comes to liquidity, casts a shadow over the DeFi horizon.
At its core, fragmented liquidity — the place out there liquidity is unfold throughout a number of buying and selling venues—is the explanation why decentralized protocols have did not seize the vast majority of quantity from centralized exchanges inside the area. It’s hindering DeFi’s skill to onboard the following wave of customers, as the price of transferring property from numerous chains doesn’t make it possible for customers.
If this phenomenon persists, we shall be repeatedly reliant on centralized entities, which is clearly incompatible with DeFi’s ethos. As an business, we have to resolve the fragmentation paradox to retain the core tenets of decentralization whereas offering enough liquidity to make sure the long-term sustainability of DeFi, and to make the onboarding of latest customers seamless.
The fragmented liquidity challenges
The problems surrounding fragmented liquidity boil down to 3 predominant areas: worth inefficiency, poor UX and broader market impacts.
The character of fragmentation means it’s inherently inefficient. In a fragmented market, completely different platforms could show completely different costs for a similar asset on the identical time. This implies merchants would possibly battle to get the very best worth by advantage of not being linked to the best platform. As a result of merchants must entry a number of venues to attain the very best worth, this has a knock-on impact of upper transaction prices.
Having to buy round for the very best worth inevitably results in a poor consumer expertise. Participating with completely different platforms to attempt to obtain probably the most optimum worth provides an pointless layer of complexity and can seemingly deter customers from partaking with DeFi. Aggregation is beginning to resolve this drawback, however the underlying concern stays.
When liquidity is fragmented, even comparatively small trades can have a big influence in the marketplace worth of an asset, leading to slippage. The value differentials throughout platforms additionally give refined merchants with entry to extra superior expertise the chance to reap the benefits of arbitrage alternatives. Not solely does this threat growing regulatory scrutiny of the sector, nevertheless it additionally goes in opposition to the core ethos of DeFi — to democratize monetary companies and allow open and honest entry for all.
All of those components complicate the method of partaking with DeFi and create pointless boundaries to entry for brand new customers seeking to discover alternatives inside the DeFi area.
Band-aid options to an existential risk
Thus far, the business has did not adequately resolve the problem. At current, if a consumer desires to conduct a cross-chain commerce, they’re confronted with quite a few obstacles, all compounded by the very fact liquidity is scattered throughout so many buying and selling venues.
Wrapped tokens and bridges are probably the most extensively used options up to now. However they not solely introduce pointless threat and complexity into the DeFi system — every week doesn’t appear to go by with out listening to of one other bridge exploit — however they exacerbate the fragmentation drawback by providing many non-fungible variations of the identical asset.
Even with these band-aid options, liquidity in DeFi nonetheless isn’t what it might and must be. If we stock on as we’re with out correctly addressing the liquidity concern, DeFi could by no means attain the purpose of mass adoption.
Potential options
Consolidation is of course occurring. The final 18 months have compelled smaller venues to shut and for options to congregate round stablecoins as a base pair with the intention to handle a shrinking market with fewer synthetic incentives.
That being mentioned, aggregation and consolidation may be additional developed. We’re seeing this with the introduction of intent-based techniques and cross-chain aggregation with UniswapX, but additionally with the adoption of JIT liquidity techniques within the cross-chain area and a lot better aggregator companies for single and multi-chain routes, reminiscent of SquidRouter and xDeFi Pockets. Native asset help is essential to remove the necessity for bridges and wrapped property which essentially fragment liquidity for a given asset.
The higher DeFi can leverage aggregation techniques, environment friendly market constructions and supply a consumer expertise that may compete with the centralized exchanges in velocity, pricing and management, the sooner the area can defragment liquidity via a means of elimination.
Simon Harman is CEO and founder at Chainflip Labs.
This text was printed via Cointelegraph Innovation Circle, a vetted group of senior executives and specialists within the blockchain expertise business who’re constructing the long run via the facility of connections, collaboration and thought management. Opinions expressed don’t essentially mirror these of Cointelegraph.
