The new solutions solving DeFi’s liquidity problem

Einstein once said, “We can not solve our problems with the same level of thinking that created them.” There’s a corollary to that statement though too: sometimes the solutions we do arrive at for today’s problems are precisely what causes tomorrow’s problems. Survive today by mortgaging the future. Appeasing an enemy to make peace, with that appeasement only emboldening the enemy’s war footing. Choose Candidate Y and the problems that come with them as a reaction to the policies of Leader X.

Nowhere is this truer than crypto. A few years ago, the crypto community grappled with the “problem” presented by centralized exchanges – namely that having any sort of custodian in charge of a trustless cryptocurrency on an exchange not only made it vulnerable to precisely the same sort of risks as the traditional currency that passes through our online banking and trading (hacks, social engineering, etc.), but also completely contradicting the underlying philosophy and value proposition of what is supposed to be decentralized, trustless currency.

Enter the solution, the appropriately named decentralized exchanges (or DEXs). But the first wave of DEXs came with its own host of problems: lack of support for fiat conversion, network congestion with attendant high fees, and, most of all, a lack of liquidity. Bitsquare/Bisq, among the oldest entities to stake a claim to the concept of a decentralized exchange, limited bank-based payments to 0.25 BTC. Other first-wave DEXs went as high as one BTC.

All of the freedoms that traders were supposed to enjoy under the auspices of a DEX were suddenly ified by the inability to make trades quickly and easily across a number of currencies.

In 2020, the DeFi boom has ushered in a new wave of decentralized finance applications and DEXs, and the “yield farming” phenomenon has provided new solutions to deal with the liquidity problem.

The evolution of liquidity for decentralized exchanges

In finding a solution to the liquidity problem, decentralized finance has promised to transform debt and value systems in the same way that email and the web transformed the way we think about and use media.

Anyone can be a borrower and anyone can be a lender. The new DEX uses smart contracts to bridge the liquidity gap issues faced by the earliest exchanges. Some of the newer exchanges, like Tokenlon, evaluate orders off-chain and then execute the swaps on-chain.

However, the current DEXs are still open to slippage. Slippage can cause large price differences between an initial order and the execution of that order, especially on what can be notoriously slow blockchains, and on larger transactions. Technically, liquidity has been achieved, but it comes at a high cost. Maybe not such a big problem if you’re a small trader, but a huge problem if you’re a whale.

Liquidity incentive programs, which have become popular, can offer some relief. Liquidity incentives for users reward those users for using the exchange protocol. Uniswap, perhaps 2020’s most popular decentralized exchange and one of the standard bearers of the emerging DeFi movement, already operates as a Constant Function Market Maker (CFMM), a type of Automated Market Maker (AMM) providing 24/7 order fulfillment trade based on total assets and liquidity pools, not a specific counterparty.

An elegant solution to the elephant in the room

By shifting trading from a specific counterparty to liquidity incentives and liquidity pools, the problem of liquidity is solved through token holders providing that liquidity to the market, while also earning those token holders their own fees in the process. This enables deeper markets for altcoins and volatility reduction simultaneously. Being a liquidity provider gives token holders a new choice and new incentives between “hodl” or selling into the exchange’s liquidity holdings.

More than just providing more options and incentives to token holders in the exciting world of decentralized finance, new liquidity structures also provide perhaps the best solution for the largest problem that has dogged crypto since the earliest days of Bitcoin. Arguably the most significant advantage enjoyed by currencies like the dollar and traditional institutions like banks is the perception of safety. Sure, maybe you’re only getting a few percentage points on those dollars that you are keeping in a savings account, but you have the peace of mind that comes with both the soundness of that dollar and an FDIC-backed financial institution.

In the new model, you place that trust perhaps in something just as unshakeable: strength in numbers. As liquidity pools grow in popularity, the assurances offered by that strength in numbers will become even more clear. On Compound, the third-largest DeFi app on Ethereum, investors can already take out options on stablecoin deposits, allowing users to hedge against the risk of a catastrophic event. As DeFi driven by pooling continues to grow, novel solutions to replace the old with the new will only grow. Popularity may drive investor crazes and bull runs, but in the case of DeFi, it can also solidify financial and technical stability.

We still have a way to go before decentralized finance completely overtakes centralized finance as the option of choice for older and younger retail investors alike, and new problems are sure to be created by the growing network of new solutions, but which path would you wager looks most like the future?

About the Author

Piers Ridyard is an entrepreneur and the CEO of Radix, a layer-one protocol for DeFi. Piers leads the company’s mission to transform decentralized finance with secure, scalable solutions. He is a graduate of the University of Manchester and the UK’s University of Law.