Liquidity is Fractured

Right now, liquidity is fractured. Decentralized finance (DeFi) has liberalized money and markets, allowing you and I to participate and gain some control. But this has also led to new challenges.

DeFi has splintered the landscape into a tapestry of different markets. Think of it like an archipelago of islands, each with its own little ecosystem. Every one of these ecosystems needs to address the same challenges, meaning that resources are being wasted.

By spreading across multiple ecosystems, DeFi protocols are having to solve the same problems over and over again. This means more work, less efficiency, and a worse experience for you, the end user.

Clearly, we need a solution. We need to find a way to seamlessly connect these separate ecosystems. We need to aggregate their liquidity and let it flow to realize the full potential of decentralized markets.

Understanding the Role of Liquidity in DeFi

Liquidity to DeFi is like water to a river. It is the fundamental resource underpinning every market, including DeFi markets. Think of it as cash, or the availability of cash.

For example, the NASDAQ is very liquid; there is cash everywhere and transactions are settled pretty much instantaneously. Conversely, the real estate market is very illiquid; deals take a long time to close and finding buyers can be next to impossible.

As you can imagine, maintaining liquidity is essential for markets. However, liquidity in DeFi works a little differently to liquidity in traditional finance (TradFi).

TradFi markets rely on simple buying and selling to maintain their liquidity. But what happens when there are more buyers than sellers or vice versa? Well they utilize market makers who provide liquidity to the market by filling buy and sell orders at a reasonable price.

Market making occurs a little differently in DeFi. Instead of using their liquidity to buy and sell, DeFi markets often utilize Automated Market Makers (AMMs). These AMMs rely on liquidity provided by users who fund pools with pairs of tokens, which other users can then trade against.

But if buyers and sellers aren’t trading directly with each other how do we determine price?

Through a pricing algorithm based on the relative quantities of the tokens in the pool.

Think of it like this; if there are two token A’s in a pool and only 1 token B, then token B will be double the price of token A. Pretty simple right? It can get a lot more complex but that’s the gist of it.

The most famous example of a pricing algorithm is Uniswap’s constant product formula — xy=k. Here x and y represent the quantities of the two tokens in the liquidity pool, and k is a constant value.

The pools these AMMs use to determine asset pricing are referred to as ‘liquidity pools’ and they are the essential innovation behind most DeFi markets. The way they work is pretty simple; users add tokens to the pool and these tokens are used to facilitate trades. In return, the users (referred to as liquidity providers or LPs) get a cut of the transaction fees.

Since the transaction fees are the incentive, in theory a supply and demand relationship for liquidity should form whereby LPs reallocate towards those pools offering the best risk adjusted rewards. However, as we’ll find out later, this is often not the case.

LPs in DeFi are indispensable. Trade execution, price stability, slippage and overall efficiency are contingent on the direct influence of their liquidity. A market with a healthy amount of liquidity can absorb large orders without significant impact. On the other hand, thin liquidity causes significant slippage resulting in trader dissatisfaction.

Without LPs, DeFi would probably need to turn to centralized market makers, which would undoubtedly take away from the industry’s core ethos of decentralization.

Nevertheless, retaining LPs is hard. DeFi platforms are constantly competing to attract them to their markets using incentives. They engineer their ecosystems to retain liquidity, making inflow easy and outflow hard.

These siloed ecosystems have caused a problem; fragmented liquidity.

The Problem — Illiquid Liquidity

Liquidity pools were an amazing innovation for capital markets. They created a permissionless alternative to market makers, allowing regular users like you and I to become LPs and get value out of the market.

Despite this, there are a number of barriers in place which stop liquidity from flowing. Think of these barriers like dams on a river, stifling the flow between two reservoirs.

Obvious examples are barriers such as all of the different blockchains and the numerous projects operating on each, which frequently lack interoperability. Others, however, are less obvious, such as liquidity mining.

What is liquidity mining?

It’s a strategy used by platforms to incentivise users to invest in their pools. It involves rewarding LPs with additional tokens, on top of the transaction fees they already earn for depositing their assets into a liquidity pool. These rewards are usually distributed in the platform’s native tokens and are often quite substantial, especially during the early stages of a project’s launch to attract that essential initial base of liquidity. It’s worth noting that these strategies are generally unsustainable given that it’s not coming from the revenue of the protocol itself.

Platforms emerged that aggregate liquidity using liquidity mining and direct it towards pools across different DEXs. This innovation is referred to as ‘protocol owned liquidity’. These protocols accumulate liquidity from their users and those same users direct it using governance tokens.

Competition for governance power on these platforms emerged pretty quickly. Users realized the power they could have over the platform’s future, including decisions on fee structures, reward distributions, and the introduction of new features, by accumulating governance tokens. As a result, those same users started adding liquidity to get governance tokens.

However, this can lead to an oversupply of liquidity relative to volume as more and more users flock to these platforms. Liquidity is only there to facilitate trades. So if there is a lot of liquidity, and not much volume, then a lot of that liquidity is just sitting there, getting inflationary rewards and not being used.

This underutilisation of liquidity can be a big drain within an ecosystem. At the same time, surrounding ecosystems not receiving liquidity from these platforms can face an undersupply of liquidity relative to volume.

For example, many projects hosted on Curve Finance during the ‘Curve Wars’ likely faced an oversupply of liquidity relative to volume. This oversupply, while great for traders, results in a number of issues for LPs including:

• Diminished Returns — As the supply of liquidity in the pool increases, the individual share of transaction fees and rewards for each LP decreases, assuming trading volume does not increase during that time.
• Divergent Loss — Because there isn’t enough volume, the ratio of arbitrage trading to organic trading skyrockets. The LPs are still exposed to impermanent loss, but may not be recouping their losses due to diminished returns.
• Lower Capital Efficiency — Lots of liquidity facilitating not much trading volume means that liquidity is not being used to its full potential. As a result, the system will be inefficient because a significant portion of the capital locked in the pool is not actively generating returns.

Meanwhile this oversupply of liquidity means demand is likely not being addressed elsewhere. Think of them like dry spots that the rivers of liquidity are flowing around rather than through. Smaller and emerging markets are hit hard by this issue.

Consequently, these projects struggle to gain traction, stifling innovation and diversity within the ecosystem. This is because liquidity undersupply is especially damaging for traders, causing:

• High Slippage — Undersupplied pools have less liquidity to facilitate trades, which results in high slippage, especially for larger transactions. This means traders might receive significantly less of the asset they are buying or sell their asset at a lower price than expected.
• Worse Prices — The lack of liquidity can lead to worse prices for traders, as the execution price of trades stays further and further from quote price.
• Limited Trading Opportunities — Traders might find it difficult to execute large trades or take advantage of arbitrage opportunities due to the limited liquidity.

As well as the following effects for LPs:

• Impermanent Loss — While impermanent loss can occur in any liquidity pool, the effects can be greater in undersupplied pools as a result of high slippage and the other detriments to the trader.
• Higher Risk of Pool Manipulation — Smaller pools might be more susceptible to manipulation, such as pump and dump schemes, which can put LPs at risk. Manipulators can more easily influence prices in a pool with low liquidity, leading to significant losses for LPs.

These are just some of the problems associated with fractured and siloed liquidity. The vision for a decentralized free flowing marketplace of liquidity appears to only have been achieved within ecosystems, rather than between them. Liquidity might not be sticky, but it does appear to be trapped, and therefore underutilized.

Siloed Ecosystems and Fractured Liquidity

DeFi today is fractured. This is no secret, interoperability solutions and cross-chain projects have been around for sometime to address this problem. However, they have failed to completely solve the problem.

Simply compare DEX volume vs bridge volume and you’ll see the evidence; for every dollar sent over a bridge, more than 15 are traded on DEXs as of January 2024. Even without taking into account all the other activities that take place on a blockchain, this demonstrates that liquidity spends most of its time within a particular ecosystem. This fractured liquidity landscape presents significant challenges to the overarching goal of DeFi: to create a unified, accessible, and efficient financial system.

However, the effects extend beyond traders and LPs.

Siloed ecosystems and their fractured liquidity stiffles exchange of assets and distribution of capital. Moreover, they hinder the growth and adoption of smaller or emerging projects and platforms that could benefit from greater liquidity, as capital remains concentrated in more established ecosystems.

The division of liquidity across multiple, unintegrated ecosystems leads to inefficiencies in capital allocation, as assets remain locked within their native environments, unable to be leveraged where they might be most needed or most profitable.

Bridging these siloed ecosystems is not each. Blockchain are often incompatible. Their compatibility issues stem from diverse architectures, consensus mechanisms, and smart contract languages. While blockchain bridges and wrapped tokens offer solutions, they bring new complexities and risks. Notable exploits include:

• Poly Network (August 2021) — Over $600 million stolen due to a vulnerability.
• Wormhole (February 2022) — $320 million lost through unauthorized minting of wETH.
• Harmony’s Horizon Bridge (June 2022) — About $100 million compromised via a multi-sig wallet breach.

Additionally, regulatory challenges across different jurisdictions add to the complexity, potentially affecting liquidity flows.

Solving the Problem — Bridging the Gaps

New tech such as cross-chain bridges and interoperability protocols have failed to address the problem of fractured liquidity. This is due to their high costs, slow speeds and user experience challenges.

Think about it, how are you supposed to monitor all of the different markets without excessively dividing your attention? And when you go to move assets from one network to another the issues don’t stop. The pain points are many and not easy to abstract away.

Aggregators and super apps are the answer.

They provide a unified user interface wherein users get access to a complete view of the market and can manoeuvre seamlessly. Users can see multiple ecosystems, meaning they can make informed decisions without having to navigate through multiple platforms.

With all barriers removed, a true cross chain DEX aggregator could create a more efficient supply and demand market for liquidity on-chain. Projects across DeFi would have access to the same opportunities and incentive structures to direct liquidity to their platforms.

Not only would this be beneficial for projects, but for users it would offer them optimized trading routes. These routes can provide better rates and lower slippage as well as access to a wider range of tokens and trading pairs. Assuming sufficient incentive structures have been put in place, this application would be the superset of all markets, or a ‘meta-market’. Projects like Curve Finance have done this in their own ecosystem. However, there hasn’t been a successful cross chain solution barring partial implementations.

The opportunity here is massive and will revolutionize the way liquidity is utilized across DeFi. By creating a ‘meta-market’, liquidity would no longer be confined to individual ecosystems but could flow freely to where it is most needed, maximizing efficiency and profitability for both liquidity providers and traders.

Conclusion

DeFi has shown us the impact of liquidity on markets by demonstrating what happens when liquidity is fractured.

This fracturing, caused by the decentralization and democratization of markets, has resulted in the creation of liquidity bottlenecks, stifling the potential for a more unified and efficient financial system. We need bridges and aggregation layers, systems that facilitate the flow of liquidity and transactions between ecosystems.

In doing so, we can break the barriers between siloed ecosystems and ensure liquidity is allocated where it is needed most rather than where it is being trapped.

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