April 16, 2024

Fragmentation in DeFi: DeFi’s liquidity challenge

Yet, as with any transformational shift, growing pains are inevitable. Among these, fragmentation, particularly in terms of liquidity, casts a shadow over the DeFi horizon. 

DeFi enthusiasts know all too well the benefits that decentralization can bring to finance: trustless operations, innovation and greater control for users. 

Yet, as with any transformational shift, growing pains are inevitable. Among these, fragmentation, particularly in terms of liquidity, casts a shadow over the DeFi horizon. 

At its core, fragmented liquidity — where available liquidity is spread across multiple trading venues—is the reason why decentralized protocols have failed to capture the majority of volume from centralized exchanges within the space. It is hindering DeFi’s ability to onboard the next wave of users, as the cost of moving assets from various chains does not make it feasible for users. 

If this phenomenon persists, we will be continuously reliant on centralized entities, which is clearly incompatible with DeFi’s ethos. As an industry, we need to solve the fragmentation paradox to retain the core tenets of decentralization while providing sufficient liquidity to ensure the long-term sustainability of DeFi, and to make the onboarding of new users seamless. 

The fragmented liquidity challenges 

The issues surrounding fragmented liquidity boil down to three main areas: price inefficiency, poor UX and broader market impacts.

The nature of fragmentation means it is inherently inefficient. In a fragmented market, different platforms may display different prices for the same asset at the same time. This means traders might struggle to get the best price by virtue of not being connected to the right platform. Because traders need to access multiple venues to achieve the best price, this has a knock-on effect of higher transaction costs.

Having to shop around for the best price inevitably leads to a poor user experience. Engaging with different platforms to try and achieve the most optimum price adds an unnecessary layer of complexity and will likely deter users from engaging with DeFi. Aggregation is starting to solve this problem, but the underlying issue remains.

When liquidity is fragmented, even relatively small trades can have a significant impact on the market price of an asset, resulting in slippage. The price differentials across platforms also give sophisticated traders with access to more advanced technology the opportunity to take advantage of arbitrage opportunities. Not only does this risk increasing regulatory scrutiny of the sector, but it also goes against the core ethos of DeFi — to democratize financial services and enable open and fair access for all.

All of these factors complicate the process of engaging with DeFi and create unnecessary barriers to entry for new users looking to explore opportunities within the DeFi space. 

Band-aid solutions to an existential threat

So far, the industry has failed to adequately resolve the issue. At present, if a user wants to conduct a cross-chain trade, they’re faced with numerous obstacles, all compounded by the fact liquidity is scattered across so many trading venues.

Wrapped tokens and bridges are the most widely used solutions so far. But they not only introduce unnecessary risk and complexity into the DeFi system — a week doesn’t seem to go by without hearing of another bridge exploit — but they exacerbate the fragmentation problem by offering many non-fungible versions of the same asset.

Even with these band-aid solutions, liquidity in DeFi still isn’t what it could and should be. If we carry on as we are without properly addressing the liquidity issue, DeFi may never reach the point of mass adoption.

Potential solutions

Consolidation is naturally occurring. The last 18 months have forced smaller venues to close and for solutions to congregate around stablecoins as a base pair in order to address a shrinking market with fewer artificial incentives.

That being said, aggregation and consolidation can be further developed. We are seeing this with the introduction of intent-based systems and cross-chain aggregation with UniswapX, but also with the adoption of JIT liquidity systems in the cross-chain arena and much better aggregator services for single and multi-chain routes, such as SquidRouter and xDeFi Wallet. Native asset support is crucial to eliminate the need for bridges and wrapped assets which fundamentally fragment liquidity for a given asset.

The better DeFi can leverage aggregation systems, efficient market structures and provide a user experience that can compete with the centralized exchanges in speed, pricing and control, the faster the space can defragment liquidity through a process of elimination.

Simon Harman is CEO and founder at Chainflip Labs.


This article was published through Cointelegraph Innovation Circle, a vetted organization of senior executives and experts in the blockchain technology industry who are building the future through the power of connections, collaboration and thought leadership. Opinions expressed do not necessarily reflect those of Cointelegraph.

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