DeFi lovers know all too nicely the advantages that decentralization can deliver to finance: trustless operations, innovation and better management for customers.
But, as with every 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 obtainable 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 throughout the area. It’s hindering DeFi’s capacity to onboard the following wave of customers, as the price of shifting property from numerous chains doesn’t make it possible for customers.
If this phenomenon persists, we will likely be repeatedly reliant on centralized entities, which is clearly incompatible with DeFi’s ethos. As an trade, 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 recent customers seamless.
The fragmented liquidity challenges
The problems surrounding fragmented liquidity boil down to a few major areas: value inefficiency, poor UX and broader market impacts.
The character of fragmentation means it’s inherently inefficient. In a fragmented market, totally different platforms could show totally different costs for a similar asset on the similar time. This implies merchants would possibly battle to get the perfect value by advantage of not being related to the suitable platform. As a result of merchants must entry a number of venues to realize the perfect value, this has a knock-on impact of upper transaction prices.
Having to buy round for the perfect value inevitably results in a poor consumer expertise. Partaking with totally different platforms to try to obtain probably the most optimum value provides an pointless layer of complexity and can doubtless deter customers from participating with DeFi. Aggregation is beginning to clear up this downside, however the underlying concern stays.
When liquidity is fragmented, even comparatively small trades can have a big influence available on the market value of an asset, leading to slippage. The value differentials throughout platforms additionally give refined merchants with entry to extra superior expertise the chance to make the most of arbitrage alternatives. Not solely does this danger growing regulatory scrutiny of the sector, but it surely additionally goes towards the core ethos of DeFi — to democratize monetary providers and allow open and honest entry for all.
All of those elements complicate the method of participating with DeFi and create pointless boundaries to entry for brand spanking new customers trying to discover alternatives throughout the DeFi area.
Band-aid options to an existential risk
To this point, the trade has did not adequately resolve the difficulty. At current, if a consumer needs 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 thus far. However they not solely introduce pointless danger 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 downside 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 needs to be. If we supply 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 pressured smaller venues to shut and for options to congregate round stablecoins as a base pair with a purpose to tackle a shrinking market with fewer synthetic incentives.
That being mentioned, aggregation and consolidation will 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 enviornment and a lot better aggregator providers for single and multi-chain routes, similar to SquidRouter and xDeFi Pockets. Native asset assist is essential to remove the necessity for bridges and wrapped property which basically fragment liquidity for a given asset.
The higher DeFi can leverage aggregation techniques, 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 by way of a means of elimination.
Simon Harman is CEO and founder at Chainflip Labs.
This text was printed by way of Cointelegraph Innovation Circle, a vetted group of senior executives and specialists within the blockchain expertise trade who’re constructing the longer term by way of the facility of connections, collaboration and thought management. Opinions expressed don’t essentially mirror these of Cointelegraph.
