The problem of liquidity fragmentation affects all financial markets, including those in traditional finance. However, it has proven particularly problematic in the area of decentralized finance. As such, there is great optimism about the innovative new solutions developed by protocols such as Yellow Network and Orbs, leveraging the unique capabilities of Layer 3 infrastructure.
Liquidity fragmentation is the problem that financial markets face when liquidity – financial capital – is distributed across multiple trading venues rather than 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 are suffering major headaches when there is a lack of liquidity on the platforms they use. Therefore, it can sometimes be almost impossible for users to complete trades at the desired price, especially when trading in higher volumes. With the rise of thousands of altcoins and numerous different blockchains, these issues have become much more complicated. The fragmentation is further 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 balances 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 fees on each trade as a return. In theory, there should be more than enough crypto users in the world willing to deposit their funds into liquidity pools. But the emergence of so many DEXs and DeFi protocols means that this liquidity is heavily diluted and spread across hundreds of different pools.
Fragmented liquidity issues
The availability of liquidity is a key factor that can determine the success or failure of a new DeFi protocol or DEX trading venue. If a platform does not have enough liquidity to allow larger trades or swaps with lesser-known tokens, traders will simply go elsewhere and the project will fail.
In DEXs, liquidity fragmentation causes traders problems such as inconsistent prices across exchanges, higher fees and transaction costs, and slippage, which is when a transaction is executed at a higher price than the trader had hoped. These disadvantages often negate the slim profit margins that many traders benefit from.
If a DEX platform does not have access to sufficient liquidity, traders will be forced to pay higher fees to prioritize their transactions. Additionally, they may need to split larger trades into multiple transactions, sometimes even across more than one DEX, resulting in higher transaction costs.
DEX aggregators have emerged as an obvious solution to this problem. These platforms essentially combine the liquidity pools of multiple DEXs into one much larger pool.
However, DEX aggregators are not a perfect solution as they often charge their own fees and can suffer from higher network latency, meaning trades take longer to complete, often to the detriment of the trader. They also add further complexity to the already difficult trading business on a DEX platform, and their use of blockchain bridges and smart contracts creates the potential for new security vulnerabilities.
Is Layer-3 the answer?
The Layer 3 network’s recent innovations could help solve DeFi’s liquidity problems once and for all. One of the most promising answers appears to be Yellow Network’s ClearSync protocol, which is intended to play the same role as a clearinghouse in the traditional financial world.
Yellow Network is about enabling high-frequency trading across blockchain networks, and it works by conducting the majority of trades offline. The ClearSync protocol is Yellow’s biggest innovation. It enables traders to make secure transactions by managing collateral and ensuring everyone agrees on the required amount. It uniquely brings together all parties, exchanges, blockchains and trading companies, creating a network of brokers and enabling a more efficient trading infrastructure.
ClearSync relies on automated smart contracts that require users to deposit YELLOW tokens as security. By using collateral, participants can ensure that they are trading with others in good faith, as no one can defraud others. The system provides regular updates on the collateral ratio so users know their trades are secured. If someone feels uncomfortable, they can ask the party they are trading with to provide additional collateral.
With ClearSync, the actual trades of brokers and trading firms are conducted using Hashed Timelock Contracts, which are a special type of smart contract that allows the secure transfer of assets between two parties. HTLCs ensure that transfers occur at a specific time and provide users with the ability to perform secure swaps, even across blockchains.
ClearSync’s government channels merely manage the collateral that underpins each trade, but the protocol does not know the details of each trade, meaning privacy is guaranteed. The actual trades take place off-chain according to Yellow’s rules and only transact on-chain when the state channel is closed and collateral is returned.
Another innovative idea is the Liquidity Hub, created by the Layer 3 infrastructure protocol Orbs. As a decentralized optimization layer on top of the AMM, Liquidity Hub is a highly 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 DEXs with the ability to facilitate trading across other platforms, including other AMMS, third-party solvers, and even institutional traders, to mitigate the price impact of automated market makers.
Whenever a trade is opened, the Liquidity Hub searches the participating DEXs and aggregators to find the most favorable rate for the trader. If no AMM can be found, it simply returns to the original AMM and looks for the best trading price there. It is a non-custodial platform where all assets in users’ wallets remain on-chain and every transaction is routed through Liquidity Hub’s smart contract. This will enable trades that meet the terms of both parties and execute them at the most favorable rates, above the price offered by the DEX’s own AMM.
Another advantage of Liquidity Hub is the Maximum Extractable Value protection mechanism, which helps protect liquidity providers. Additionally, Orbs’ decentralized infrastructure prevents trade manipulation.
Innovation will win
Liquidity fragmentation in DeFi and DEXs is an ongoing challenge, but the introduction of cutting-edge Layer 3 solutions is helping to address the issues associated with it. The examples above illustrate how the crypto industry is innovating at breakneck speed to overcome the major hurdles it faces on its path to the mainstream.
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