The Evolution of DeFi Liquidity Infrastructure

Why is Liquidity Important?

The number of Ethereum addresses interacting with DeFi protocols crossed 3.4 million in Q3 of 2021, an almost 200% increase since the start of the year. Serving these users are DeFi dapp verticals extending across lending and borrowing, options, yield aggregation, portfolio management, DEXs and AMMs, disrupting and democratizing everything traditional finance had to offer. In the last year, we’ve seen all the low hanging fruits of DeFi picked, iterated and forked across every possible chain, casually demonstrating the power of open-source code. The next wave of innovation in liquidity management will build on these DeFi primitives and we will likely see solutions completely unique from traditional finance.

Investment banks, hedge funds and VCs are all looking for their way in. In the current state, investment capital disproportionately subsidizes the number of real builders and projects developing in this space. Even centralized exchange market makers want to dip their toes into DeFi, going as far as masquerading as venture capital arms. At the end of the day, everyone wants a slice of the pie; some don’t even care if it's any good, even fewer have the ability to add true value.

In this rush, record breaking capital inflow was locked into DeFi this year, upwards of $104 billion. Last month, a family office wanted to invest in Klima Dao. They read about it in a tweet and wanted to know how and where to put their millions to power the carbon economy. But alas, the liquidity pools can’t possibly handle a transaction of that size, clearly proving that the lack of liquidity is still painfully evident when trading long-tail and pre-price discovery assets. Large trades in low liquidity pools experience severe price impact and slippage. As powerful as DeFi can potentially be, one major obstacle it must overcome before major institutional adoption is liquidity efficiency and depth.

Several methods are currently available to minimize price impact: one can find a pool with the deepest market with the most liquidity in the desired price range or manually execute smaller orders over time. Q3 of this year saw incentives schemes launched concurrently across Avalanche, Fantom, Celo, Elrond and more. The problem of insufficient liquidity has been exacerbated by the cross-chain segregation of assets. As a greater number of DEXs emerge across Layer 1s and cross-chain solutions mature and scale, we see the flow of capital enabled by bridging infrastructure but at the same time, hindered by the thinning of liquidity across chains.

Current Solutions to Capital Efficiency and Liquidity

Uniswap V3 is a revolutionary piece of DeFi infrastructure that helps alleviate the problem of lack of liquidity. It was created to provide greater capital efficiency by placing concentrated liquidity around the current market price. Not only did it enable a raise capital efficiency by 4000x, it allowed liquidity providers with higher returns on their capital. For a while, this was a godsend- that is, until liquidity providers were getting priced out of their pre-set ranges. Aside from trading fees which can range anything between 0.3 - 1%, transaction fees on Ethereum made it uneconomical to reallocate your capital on the Uniswap V3 price curve. In periods of low network usage, you might be lucky to get away with paying $45 for a transaction, if you time your trade to coincide with a NFT mint, godspeed.

It didn’t take long for several protocols to come up with a solution - vaults that automated active liquidity provision. These smart vaults from Visor finance, Unipilot and Lixir allow you to deploy your assets in pools on Uniswap V3 with fee optimization, market-making strategies, options to reinvest your fees and even optimize liquidity mining. Unipilot takes this one step further by allocating fees earned to a treasury represented as an index fund which the native token can take claim to.

The issuance of smart vaults removes the need for users to hold illiquid NFTs as proof of LPs and can even open up the opportunity for concurrent liquidity mining without the loss of asset custody. Alchemist's crucibles are one such solution, their multiplier mechanism is one particularly elegant feature to reward long-term participants. The greatest down side of concentrated liquidity however, is hyper impermanent loss. A recent study showed that 50% of Uni V3 LP providers made a loss.

Chain specific DEX aggregators were another welcomed solution to the lack of depth in liquidity. An aggregator fetches the best price across multiple DEXs and executes the swap by routing for the most optimal and effective price. This was preceded by cross-chain liquidity aggregators that took DEX aggregation to the next level, further reducing the friction for cross-chain arbitrage and cross-chain flash loans. The reliability of cross chain bridges is consistently being tested for vulnerabilities, DeFi protocols have already seen a record number of exploits this year - totalling $680 million, several of these attributed to cross-chain liquidity platforms.

Whilst some projects focused on the hard tech, others analysed the concentration of DEX trading volumes to assign the most profitable strategies and models for market making in DeFi. 0x’s Request for Quote(RFQ) system is one that allows professional market makers to bring CEX liquidity to DEXs, another is hedging their positions with futures and options. At the moment, most AMMs are only efficient in stablecoins and highly traded pairs. Long-tail asset pairs however, and their non-correlative nature makes it incredibly difficult for market makers to develop sufficient predictive ability.This leaves a lucrative market share for future AMMs to capture. This is of course an exception in extreme market conditions where there is a flight-to-safety period like we saw in late May.

Solutions on the Horizon

There are several projects on the horizon that may provide a sustainable solution to liquidity management and are building the future of liquidity infrastructure. In a piece released by Paradigm written by Dave White, Dan Robinson and Hayden Adams, Time-weighted average market maker (TWAMM) was introduced. This could be one of the imminent solutions implemented in DeFi potentially using Flashbots RPC or a privacy-centric layer 2 like Aztec to circumvent attack vectors such as information leakage and sandwiching. The analogy to this solution in traditional finance is TWAP (Time-weighted Average price). In a normal AMM with immediate onchain execution, not only would you be vulnerable to sandwich attacks you would pay abscenly high gas fees. TWAMM resolves this by breaking down one large order to infinitely small virtual orders to be executed smoothly long-term, say over 2,000 blocks. The cumulative effect of gas fees is further minimized by pooling orders.

Despite the heralding of cross-chain liquidity bridges reducing painfully long challenge periods from Layer 2 scaling solutions, the current fragmentation of bridging services is overall, a terrible user experience. The friction for asset distribution and bridging between networks is particularly evident during market crashes, where existing infrastructure is crippled by excessive network usage. This is why DeFi can’t wait for Dapp integration of cross-chain liquidity aggregators or chain-agnostic liquidity pools such as Gravity DEX.

Imagine you want to do a swap for a long tail asset with low market cap and liquidity. Currently, in the present day you would look at the available liquidity pools on various DEXs, you compare trading fees, liquidity depth, transaction fees and cross check with your portfolio of assets to make sure that you have enough funds distributed in the same network as the available swapping platform. After much contemplation and digging, not only have you lost the entry price you wished for, you’ve settled for higher transaction and trading fees because of your distribution of available funds. With Dapp integration you would be able to do this seamlessly. With one click - this solution could route your swap to ensure you have the best price after evaluating all available DEXs across multiple chains, accounting for fees, price impact and slippage. All without you leaving the native swap platform.

In liquidity solutions for the future we may also see greater use cases for liquidity infrastructure derivatives like Gelato network’s G-UNI. G-UNI is a neutral un-opinionated framework for liquidity management allowing the pool manager to control rebalances built on top of Gelato Network. It performs only two functions:

• Wraps the original NFT of a Uniswap v3 position into a ERC-20 token
• Auto-compound fees back into the pool.

Future functions of migration tools include automatic liquidity transfer from Univ2 to G-UNI. Pool managers can be a multi-sig or a smart contract and can be integrated into DeFi 2.0 products to enable better treasury management. Protocols such as Tokemak, Olympus Dao and Liquity for example could issue actively managed LP-bonds to boost capital efficiency during bond periods.

Once the underlying infrastructure of active liquidity management has been established, the crypto native community can then easily deploy and create new vault strategies. Fostering and leveraging community involvement will undoubtedly be each project’s greatest strength.

The Next Wave of DeFi Liquidity Infrastructure

As we see greater institutional utilization of DeFi and scaling investments, we need better, broader, all encompassing solutions. Not only for the user, but for the overall operational and capital efficiency of the entire DeFi ecosystem.

The next generation of solutions should provide a frictionless experience for the DeFi user trading across chains, it would aggregate automated smart liquidity vaults across multiple AMMs on the backend. To take this one step further, smart contracts could automate liquidity allocation to pools across chains with the highest demand of trading volume. These tools could then facilitate cross-chain market making for the next wave of DeFi investors. On top of current DeFi infrastructure, it will also be exciting to see innovative DeFi liquidity composability, interoperability solutions and more secure, stable bridges.

With greater capital efficiency in liquidity mining, protocols can build more sustainably without allocating a large portion of their token supply to incentivise liquidity mining rewards. When token emissions allocated for liquidity mining cease in a few years, DeFi yields will eventually plateau and the mirage of perpetual growth will likely come to an abrupt end. It is then liquidity management infrastructure and their derivatives that will become ever more crucial.

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