DeFi enthusiasts know all too well the benefits that decentralization can bring to finance: reliable operations, innovation, and greater control for users.
Still, growing pains are inevitable, as with any transformational shift. Of these, fragmentation, especially in terms of liquidity, casts a shadow over the DeFi horizon.
At its core, fragmented liquidity – where available liquidity is spread across multiple trading platforms – is why decentralized protocols have failed to capture the majority of volume from centralized exchanges within the space. It hinders DeFi’s ability to attract the next wave of users because the costs of moving assets across chains make it infeasible for users.
If this phenomenon continues, we will continue to rely on centralized entities, which is clearly incompatible with the ethos of DeFi. As an industry, we must solve the fragmentation paradox to preserve the core principles of decentralization while providing sufficient liquidity to ensure the long-term sustainability of DeFi, and to ensure seamless onboarding of new users.
The fragmented liquidity problems
The issues surrounding fragmented liquidity boil down to three main areas: pricing inefficiency, poor UX, and broader market impacts.
The nature of fragmentation means that it is inherently inefficient. In a fragmented market, different platforms can display different prices for the same asset at the same time. This means that traders may struggle to get the best price because they are not connected to the right platform. Because traders need to access multiple locations to get 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. Collaborating with different platforms to try to achieve the most optimal price adds an unnecessary layer of complexity and will likely deter users from engaging with DeFi. Aggregation is beginning to solve this problem, but the underlying problem remains.
When liquidity is fragmented, even relatively small transactions can have a significant impact on the market price of an asset, leading to slippage. The price differences between platforms also give advanced traders with access to more advanced technology the opportunity to take advantage of arbitrage opportunities. This not only risks increasing scrutiny of the sector, but also goes against the core ethos of DeFi: democratize financial services and enable open and fair access for all.
All these factors complicate the process of interacting with DeFi and create unnecessary barriers to entry for new users looking to explore the possibilities within the DeFi space.
Band-Aid solutions for an existential threat
So far, the sector has failed to adequately solve the problem. Currently, if a user wants to conduct a cross-chain transaction, they face numerous obstacles, all exacerbated by the fact that liquidity is spread across so many trading platforms.
Wrapped tokens and bridges are the most commonly used solutions to date. But not only are they introducing unnecessary risk and complexity to the DeFi system – not a week seems to go by without hearing of another bridge exploit – but they are exacerbating the fragmentation problem by introducing many non-fungible versions of the same asset offer.
Even with these band-aid solutions, liquidity in DeFi is still not what it could and should be. If we continue as we are without properly addressing the liquidity problem, DeFi may never reach the point of mass adoption.
Potential solutions
Consolidation is a natural phenomenon. The past 18 months have forced smaller venues to close and rally solutions around stablecoins as a base pair to address a shrinking market with fewer artificial incentives.
That said, aggregation and consolidation can be further developed. We see 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. Supporting indigenous assets is critical to eliminating the need for bridges and wrapped assets, which fundamentally fragment liquidity for a given asset.
The more DeFi can leverage aggregation systems and efficient market structures and deliver a user experience that can compete with the centralized exchanges in terms of speed, pricing and control, the faster the space can defrag liquidity through a process of elimination.
Simon Harman is CEO and founder of 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. The opinions expressed do not necessarily reflect those of Cointelegraph.