The problem of liquidity fragmentation is one that affects all financial markets, including those in traditional finance. However, it has proven to be especially troublesome in the realm of decentralized finance. So there’s a lot of optimism surrounding the innovative new solutions created by protocols such as Yellow Network and Orbs, which are taking advantage of the unique abilities of Layer-3 infrastructure.
Liquidity fragmentation is a term that’s used to describe the problem faced by financial markets when liquidity – financial capital – is spread across multiple venues as opposed to a single, centralized marketplace. While this can be a challenge in traditional financial markets, it has become much more acute in DeFi, due to the decentralized nature of the industry.
Cryptocurrency traders and DeFi users suffer thumping headaches when there is a lack of liquidity on the platforms they use. Thus it can sometimes be almost impossible for users to complete trades at their desired price, especially when trading at higher volumes. With the rise of thousands of altcoins and numerous different blockchains, these headaches have become much more complicated. Fragmentation is exacerbated by the sheer number of trading venues that now exist in the DeFi market.
Decentralized trading platforms do not have a central authority to balance the books and instead rely on automated market makers and liquidity pools, which are funds deposited by their users. They offer depositors the chance to earn a percentage of the fees for each trade as a return. In theory, there should be more than enough crypto users in the world who are willing to deposit their funds into liquidity pools. But the emergence of so many DEXs and DeFi protocols means this liquidity is seriously diluted, spread across hundreds of different pools.
Fragmented Liquidity Headaches
The availability of liquidity is a key factor that can make or break a new DeFi protocol or DEX trading venue. If a platform doesn’t have enough liquidity to enable bigger trades, or swaps involving lesser-known tokens, traders will simply go elsewhere and the project will die.
For DEXs, liquidity fragmentation causes problems for traders such as inconsistent prices across exchanges, higher fees and transaction costs, and slippage, which is when a transaction executes at a higher price than the trader had hoped for. These disadvantages oftentimes eliminate the slim profit margins that many traders exist on.
When a DEX platform does not have access to sufficient liquidity, it will force traders to pay higher fees to prioritize their transactions. In addition, they may have to split larger trades into multiple transactions, sometimes even across more than one DEX, leading to increased transaction costs.
DEX aggregators have emerged as the obvious solution to this problem. These platforms essentially amalgamate the liquidity pools of multiple DEXs into one much larger pool.
However, DEX aggregators are not a perfect solution, as they often charge fees of their own and can suffer from higher network latencies, meaning trades take longer to complete, often to the trader’s disadvantage. They also add another layer of complexity to the already tricky business of trading on a DEX Platform, and their use of blockchain bridges and smart contracts introduces the potential for new security vulnerabilities.
Is Layer-3 The Answer?
Recent innovations by Layer-3 network may help to solve DeFi’s liquidity problems once and for all. One of the most promising answers looks to be Yellow Network’s ClearSync Protocol, which is designed to play the same role as a clearing house does in the traditional financial world.
Yellow Network is all about enabling high-frequency trading across blockchain networks, and it works by performing the bulk of trades offline. The ClearSync Protocol is Yellow’s biggest innovation, making it possible for traders to transact safely by managing collateral and ensuring everyone agrees on the amount required. It uniquely brings all parties, exchanges, blockchains, and trading firms together, creating a network of brokerages and allowing for a more efficient trading infrastructure.
ClearSync relies on automated smart contracts, in which users are required to deposit YELLOW tokens as collateral. Through the use of collateral, participants can ensure they are trading in good faith with others, as no one is able to cheat anyone else. The system provides frequent updates regarding the ratio of collateral, so users know that their trades are covered. If one should become uncomfortable, they can request the party they’re trading with to add more collateral.
With ClearSync, the actual trades are performed by brokers and trading firms using Hashed Timelock Contracts, which are a special kind of smart contract that enables the secure transfer of assets between two parties. HTLCs ensure that transfers happen at a specified time, providing a way for users to engage in safe swaps, even across blockchains.
ClearSync’s state channels simply manage the collateral that backs each trade, but the protocol doesn’t know the details of each trade, meaning privacy is guaranteed. The actual trades take place off-chain according to Yellow’s rules, and are only settled on-chain once the state channel is closed and the collateral is returned.
Another innovative idea is the Liquidity Hub that was created by the Layer-3 infrastructure protocol Orbs. As a decentralized optimization layer that sits above the AMM, Liquidity Hub is an extremely promising solution that aims to optimize liquidity on DEX platforms to mitigate price pressure and volatility.
Liquidity Hub’s architecture integrates on-chain smart contracts and off-chain logic, and everything is powered by Orbs’ decentralized network nodes. It provides a way for DEXs to facilitate trades across other platforms, including other AMMS, third-party solvers and even institutional traders, in order to mitigate the price impact of automated market makers.
Whenever a trade is opened, the Liquidity Hub will search across participating DEXs and aggregators to find the most advantageous rate for the trader. If it cannot find one, it will simply revert back to the original AMM and find the best trade price there. It’s a non-custodial platform where all assets remain on-chain in user’s wallets, with each transaction routed from Liquidity Hub’s smart contract. In this way, it facilitates trades that meet both parties’ stipulations, executing them at the most favorable rates, superior to the price offered by the DEX’s own AMM.
Another bonus of Liquidity Hub is its Maximal Extractable Value protection mechanism, which helps to protect liquidity providers. In addition, Orbs’ decentralized infrastructure prevents trade manipulation.
Innovation Will Overcome
Liquidity fragmentation in DeFi and on DEXs is a persistent challenge, but the arrival of cutting edge Layer-3 solutions is helping to address the problems associated with it. The above examples illustrate how the crypto industry is innovating at breakneck speed to overcome the major hurdles it faces as it strives to become more mainstream.