DeFi fans know all too properly the advantages that decentralization can convey to finance: trustless operations, innovation and better management for customers.
But, as with every transformational shift, rising pains are inevitable. Amongst these, fragmentation, notably by way of 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 means to onboard the following wave of customers, as the price of shifting property from varied chains doesn’t make it possible for customers.
If this phenomenon persists, we can be constantly reliant on centralized entities, which is clearly incompatible with DeFi’s ethos. As an business, we have to clear up 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 principal 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 might show completely different costs for a similar asset on the identical time. This implies merchants would possibly battle to get one of the best worth by advantage of not being related to the correct platform. As a result of merchants must entry a number of venues to realize one of the best worth, this has a knock-on impact of upper transaction prices.
Having to buy round for one of the best worth inevitably results in a poor consumer expertise. Participating with completely different platforms to try to obtain probably the most optimum worth provides an pointless layer of complexity and can doubtless deter customers from participating with DeFi. Aggregation is beginning to clear up this drawback, however the underlying challenge stays.
When liquidity is fragmented, even comparatively small trades can have a major influence available on the market worth of an asset, leading to slippage. The worth differentials throughout platforms additionally give subtle merchants with entry to extra superior know-how the chance to benefit from arbitrage alternatives. Not solely does this threat rising regulatory scrutiny of the sector, however it additionally goes in opposition to the core ethos of DeFi — to democratize monetary companies and allow open and truthful entry for all.
All of those components complicate the method of participating with DeFi and create pointless limitations to entry for brand new customers trying to discover alternatives inside the DeFi area.
Band-aid options to an existential risk
To this point, the business has did not adequately resolve the difficulty. 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 broadly used options up to now. However they not solely introduce pointless threat and complexity into the DeFi system — per 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 feature on as we’re with out correctly addressing the liquidity challenge, DeFi might 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 tackle a shrinking market with fewer synthetic incentives.
That being stated, aggregation and consolidation may be additional developed. We’re seeing this with the introduction of intent-based programs and cross-chain aggregation with UniswapX, but in addition with the adoption of JIT liquidity programs within the cross-chain enviornment and a lot better aggregator companies for single and multi-chain routes, reminiscent of SquidRouter and xDeFi Pockets. Native asset assist is essential to get rid of the necessity for bridges and wrapped property which basically fragment liquidity for a given asset.
The higher DeFi can leverage aggregation programs, environment friendly market buildings and supply a consumer expertise that may compete with the centralized exchanges in pace, pricing and management, the sooner the area can defragment liquidity via a strategy 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 know-how business who’re constructing the longer term via the ability of connections, collaboration and thought management. Opinions expressed don’t essentially mirror these of Cointelegraph.
