DeFi lovers know all too effectively the advantages that decentralization can deliver 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 rationale why decentralized protocols have didn’t seize the vast majority of quantity from centralized exchanges throughout the house. It’s hindering DeFi’s skill to onboard the following wave of customers, as the price of transferring belongings from varied chains doesn’t make it possible for customers.
If this phenomenon persists, we might 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 recent customers seamless.
The fragmented liquidity challenges
The problems surrounding fragmented liquidity boil down to a few foremost 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 identical time. This implies merchants may wrestle to get one of the best value by advantage of not being linked to the appropriate platform. As a result of merchants must entry a number of venues to attain one of the best value, this has a knock-on impact of upper transaction prices.
Having to buy round for one of the best value inevitably results in a poor consumer expertise. Partaking with totally different platforms to try to obtain essentially 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 situation stays.
When liquidity is fragmented, even comparatively small trades can have a major impression in the marketplace 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 reap the benefits of arbitrage alternatives. Not solely does this threat rising 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 participating with DeFi and create pointless boundaries to entry for brand spanking new customers trying to discover alternatives throughout the DeFi house.
Band-aid options to an existential menace
To this point, the business has didn’t 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 essentially 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 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 may and ought to be. If we feature on as we’re with out correctly addressing the liquidity situation, DeFi could by no means attain the purpose of mass adoption.
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 as a way to deal with a shrinking market with fewer synthetic incentives.
That being stated, aggregation and consolidation might be additional developed. We’re seeing this with the introduction of intent-based methods and cross-chain aggregation with UniswapX, but additionally with the adoption of JIT liquidity methods 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 help is essential to get rid of the necessity for bridges and wrapped belongings which basically fragment liquidity for a given asset.
The higher DeFi can leverage aggregation methods, environment friendly market constructions and supply a consumer expertise that may compete with the centralized exchanges in velocity, pricing and management, the sooner the house can defragment liquidity by a strategy of elimination.
Simon Harman is CEO and founder at Chainflip Labs.
This text was printed by Cointelegraph Innovation Circle, a vetted group of senior executives and specialists within the blockchain expertise business who’re constructing the longer term by the ability of connections, collaboration and thought management. Opinions expressed don’t essentially mirror these of Cointelegraph.