Building Bridges – Attracting Fresh Liquidity is Key to Solving DeFi’s Fragmentation Challenges

Liquidity fragmentation has become one of the biggest existential challenges facing DeFi, creating a poor user experience and market risks. However, the challenges are driving innovation, with solutions from Uniswap and Orbs offering new ways to attract liquidity, guarantee the best pricing, and improve UX. 

Decentralized finance was one of the biggest winners of the last bull market in 2021. Having undergone explosive growth during the DeFi summer of 2020, the segment became a magnet for innovators and copycats alike. As activity expanded beyond Ethereum to Layer 2s and other ecosystems like Solana, the bull market began to cool down, magnifying what has become one of the DeFi's biggest challenges – fragmented liquidity. 

Liquidity in DeFi can be fragmented in multiple dimensions – across a platform or across ecosystems. For instance, the liquidity of ERC-20 tokens is fragmented across Ethereum-compatible DEXs such as Uniswap, Curve, or Balancer. However, fragmentation is an even bigger challenge when moving liquidity at the Layer 1 level, between Ethereum and Solana, for example. 

Bridges were the seemingly obvious solution to overcome the challenge, but they created another set of issues as hackers began to target them. Wrapped iterations of tokens offer another Band-Aid fix, but they risk compounding the problem by introducing multiple non-fungible iterations of the same asset. 

This makes for a clunky and inefficient user experience, but that's only one issue. Fragmented liquidity makes it difficult to get the best price and creates a high risk of slippage, given the time it can take to find an optimal swap and crypto's notorious volatility.

 Furthermore, low liquidity in any given pool or DEX creates an even higher risk of volatility and the opportunity for market manipulation, given that the sums involved in pools for low-ranking altcoins can be relatively small. 

These risks also make it more likely that genuine liquidity providers will exercise caution and avoid putting a large amount of liquidity into any one pool but spread their risk across multiple pools and tokens – ironically, ensuring further fragmentation. 

Facing Up to Fresh Challenges

Crypto is now in an undisputed bullish period, and the value locked in DeFi protocols has once again begun to rise to levels not seen since 2021. Demonstrating the ability to manage liquidity effectively is a critical success factor for the segment as institutional interest is at an all-time high. 

Liquidity aggregators such as 1inch or Paraswap offer one solution, routing orders across multiple networks to find a suitable swap. Still, due to the operational complexity of enabling the swap, they don't always necessarily offer the best possible price for the end user. Factors such as routing costs or slippage can affect the price, while the need to route transactions can also result in execution issues, such as the trade being cancelled due to changing market conditions. 

Some aggregators rely on external liquidity providers or use preferred liquidity sources, which may inflate costs, while external providers may not always have the necessary liquidity to fulfill the swap. Furthermore, many aggregators depend on bridge infrastructure, meaning they are only as secure as the underlying architecture. 

Attracting New Liquidity

Innovators are now developing solutions to address the liquidity challenge. Uniswap, as the largest and longest-established AMM DEX, came up with UniswapX, which effectively outsources the routing complexity problem to third-party providers, who compete in a Dutch auction to fulfill the trade based on the best possible swap. They can use on-chain liquidity sources, or their own private inventory.

Orbs offers even more flexibility in meeting swap demands via a Layer 3 Liquidity Hub, which operates on top of the AMM and enables connection to external liquidity sources using two methods. An on-chain solver auction enables third-party providers to compete in the same way as Uniswap, filling swaps via on-chain sources like AMM pools or their own inventory. It also facilitates decentralized orders via an API, which enables institutions and professional traders, such as market makers, to submit bids to fill swaps. 

The Orbs protocol always guarantees the best price available, since the Liquidity Hub smart contract is programmed to execute the swap only under the condition that it delivers a better price than the execution price on the underlying AMM contract. Failure to fulfill this condition means it will default to a swap via the underlying AMM. 

In this way, Orbs can only enhance the trading experience; however, from a user perspective, the logic is all executed invisibly on the back end without any change to the DEX user interface. The project has also been cautious to design the protocol without creating a detrimental effect on the existing provision of liquidity. 

DeFi has come a long way in a short time, and the journey to free-flowing liquidity is likely to continue as more projects continue to innovate on developments by pioneers such as Uniswap, Curve, and Orbs. The innovative capabilities in the Web3 sphere are undoubtedly among the most powerful in addressing institutional opportunities and challenges facing the sector.