Fragmentation in DeFi: DeFi’s liquidity challenge
DeFi enthusiasts know all too well the benefits that decentralization can bring to finance: trustless operations, innovation and greater control for users.
Yet, as with any transformational shift, growing pains are inevitable. Among these, fragmentation, particularly in terms of liquidity, casts a shadow over the DeFi horizon.
At its core, fragmented liquidity — where available liquidity is spread across multiple trading venues—is the reason why decentralized protocols have failed to capture the majority of volume from centralized exchanges within the space. It is hindering DeFi’s ability to onboard the next wave of users, as the cost of moving assets from various chains does not make it feasible for users.
If this phenomenon persists, we will be continuously reliant on centralized entities, which is clearly incompatible with DeFi’s ethos. As an industry, we need to solve the fragmentation paradox to retain the core tenets of decentralization while providing sufficient liquidity to ensure the long-term sustainability of DeFi, and to make the onboarding of new users seamless.
The issues surrounding fragmented liquidity boil down to three main areas: price inefficiency, poor UX and broader market impacts.
The nature of fragmentation means it is inherently inefficient. In a fragmented market, different platforms may display different prices for the same asset at the same time. This means traders might struggle to get the best price by virtue of not being connected to the right platform. Because traders need to access multiple venues to achieve the best price, this has a knock-on effect of higher transaction costs.
Having to shop around for the best price inevitably leads to a poor user experience. Engaging with different
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