The Future of DeFi Is Aggregated Liquidity
Liquidity fragmentation in decentralized finance has become a major obstacle on the road to widespread adoption, with capital being increasingly dispersed across multiple blockchain networks and DEX platforms. The available liquidity in DeFi amounts to more than $95.7 billion, according to DeFiLlama, but that capital is siloed, hindering the efficiency and growth of its protocols.
What’s more, the problem appears to be getting more acute, as the number of new DeFi protocols and blockchains grows with each passing year. With more chains and more platforms, liquidity gets more spread out, as protocols compete to attract capital at the expense of their competitors.
Fragmented liquidity causes some serious problems for DeFi users, making it difficult to get the best price, increasing the risk of what’s known as “slippage”, or the difference between the price quotes and the price a transaction was executed at. This is because it can take time to find an optimal swap.
Other dangers posed by fragmented liquidity include the opportunities it creates for market manipulation, which is relatively easy for those with access to capital that dwarfs what is available in the limited liquidity pools of many lower-ranking crypto assets.
These risks have a knock-on effect too, as they engender more caution from liquidity providers, who become wary of putting large amounts into a single liquidity pool and instead spread their risk across multiple pools and tokens, adding to the fragmentation problem.
Liquidity Aggregation To The Rescue
The DeFi industry recognizes the challenge of liquidity fragmentation, and many protocols appear to be converging on a solution. In an interview with Bitcoin.com, Orbs Vice President of Business Development Ran Hammer said that whereas DEXs were previously concerned with creating a simpler user experience and maintaining liquidity and volume within their pools, most now understand that “the future of DeFi hinges on liquidity aggregation”.
Liquidity aggregation solutions are getting more traction at an appropriate time, as DeFi protocols are suddenly getting a lot more attention from investors amid a recovery in crypto prices. DeFi peaked during the summer of 2021, only to lose billions of dollars of value during the long and drawn-out “crypto winter” that ran from late 2021 to the latter half of 2023. With developments such as the new Bitcoin ETFs and the “halvening” drumming up more excitement around crypto, the industry has suddenly become more bullish, with BTC recently hitting an all-time high value of over $70,000, and many altcoins making similar, if not superior gains.
To capitalize on the latest bull market, many DeFi protocols are looking to liquidity aggregators to solve their liquidity fragmentation problems.
“In the past, many DEXs relied on liquidity farming to attract liquidity,” Hammer told Bitcoin.com. “While effective initially, this approach often led to high sell pressure and what’s termed a “death spiral”, and most DEXs have shifted to alternative models”.
Hammer said this has become evident with the rising dominance of DeFi liquidity aggregators such as 1inch Fusion, Cowswap, Jupiter and UniswapX, to name just a few. He explained that these protocols work by bringing fragmented liquidity from multiple sources into what effectively becomes a single, much larger pool of capital. This work is handled by a network of third-party solvers, he added.
“These solver networks execute swaps using on-chain third-party liquidity sources, enabling them to improve execution prices on most trades,” he explained.
How Does Liquidity Aggregation Work?
Uniswap’s take on liquidity aggregation is UniswapX, which relies on these networks of solvers. It uses a process similar to the traditional “Dutch auction”, enabling third-parties to bid to fulfill swaps for its users. The bidder who can offer the most optimal swap is then able to process that transaction. These solvers can use on-chain liquidity sources from other protocols and blockchains, or alternatively they can rely on their own private inventory of coins.
The implementation of Uniswapx adds to the allure of Uniswap, which, as a first-mover in the DEX space, already had some of the deepest liquidity pools around. By enabling traders to leverage its excess of capital to optimize their trades, it has become the most popular DEX platform of all.
There are competing solutions too, such as Orbs’ Liquidity Hub, which is really a Layer-3 network that connects DEX platforms to external liquidity providers via two separate methods. In addition to the on-chain solver auction employed by UniswapX, it also offers an API that can be accessed by financial institutions and professional traders such as market makers and whales, giving them a way to compete to fulfill swaps too.
It’s a promising innovation, and Orbs says it allows it to guarantee the best prices for swaps around. The Liquidity Hub uses smart contracts and will only execute swaps if it’s able to deliver a better price than the underlying AMM. In the rare cases where it cannot, the swap is simply carried out through the AMM’s own liquidity pool.
“Liquidity Hub can only improve a trader’s experience,” Hammer insisted. “If Liquidity Hub is not competitive, meaning it would only execute at a worse price for the user, or cannot execute at all, the swap will be routed through the AMM contract directly, as usual.”
Liquidity Efficiency To Accelerate Adoption
By enhancing liquidity efficiency across DEX platforms, traders get a much better service no matter which trading venue they use. In turn, this creates more stability within the DeFi ecosystem, attracting more users, activating a flywheel or virtuous cycle.
Ultimately, as more DEXs adopt liquidity aggregators, the DeFi industry will become more efficient and more relevant for a growing range of use cases, leading to benefits that go far beyond optimal trades and increased yield for liquidity providers. It will create the conditions that are essential for DeFi to thrive and offer a truly viable alternative to traditional finance.
For advocates of DeFi like Hammer, the evolution towards superior liquidity efficiency was always only ever going to be a matter of time, as the industry has always been a hub of rapid innovation. And he’s convinced that the pace of innovation will soon step up a gear.
“Tokenomics is a multifaceted issue involving incentives, game theory and regulation,” Hammer said. “We can expect to see more innovative ideas emerge in this space as it continues to evolve.”