The Problem of Fragmented Liquidity in DeFi and its Solutions

Liquidity is a longstanding pain point for decentralized finance (DeFi). In its early days, the industry struggled to attract the necessary liquidity to make it a viable option for most users. 

Then Compound introduced liquidity mining, which kicked off the DeFi Summer of 2020. In short order new protocols proliferated and liquidity pools grew deeper, but the liquidity issue remains a topic of concern even to this day - specifically the fragmentation of liquidity across the sector.

Challenges and solutions

As decentralized finance continues to incorporate additional layer-1s and layer-2s, the market becomes increasingly fragmented. Since this is inherently undesirable, there are a number of potential solutions currently being tested by the market.

Some blockchains such as Polkadot and Cosmos tout their inter-blockchain communication credentials, but in reality, this interoperability is between layer-2s co-existing on the same layer-1 network. Inter-blockchain communication is significantly harder between layer-1s.

Alternatively, wrapped tokens such as Wrapped Bitcoin (WBTC) allow the trading of Bitcoin on the Ethereum network. Almost every major blockchain has some version of wrapped tokens.

There are also cross-chain bridges that seek to bridge one layer-1 chain to another. The complex problem of fragmentation has thus far created quite a complex picture of differing solutions.

Solving fragmentation

Liquidity in DeFi has improved much in recent years, but it still lags behind centralized finance. These ongoing communication problems and a general lack of interoperability are stunting industry growth. Solving this is essential for the sector if it is ever to reach its full potential.

Cross-chain protocols such as Wormhole and Chainlink CCIP are one part of the puzzle, but relying on any single bridge brings problems of its own. Now a partnership between cross-chain specialists EYWA and Curve’s DEX is promising to solve the problem and in the process bring centralized levels of liquidity to the decentralized market.

According to Curve founder Michael Egorov, a solution comes in the form of EYWA. EYWA combines multiple bridges including Wormhole, Chainlink CCIP, LayerZero, and Axelar to make multi-chain liquidity transfers possible.

“EYWA builds a very interesting solution: it's not just your typical bridge,” says Egorov. “They solve the problem of liquidity fragmentation between chains by creatively composing Curve meta pools and the actual bridge.”

CrossCurve is a cross-chain trading and yield protocol that works on top of the existing Curve protocol. The result is unified cross-chain liquidity that aggregates existing Curve pools. The platform incorporates Ethereum, Optimism, Arbitrum, BSC, Polygon, and Avalanche blockchains.

“Having one liquidity pool working across multiple chains sounds like magic, and it is exciting to have Curve AMMs in the core of this magic,” said Egorov.

In fact, Egorov was so excited by EYWA that he became the lead investor in the project, leading a $5 million funding round that included Big Brain Holdings, Mulana Capital, and Mapleblock Capital.

With the support of Curve’s $2 billion in liquidity, CrossCurve facilitates the transfer of multiple token types from stablecoins to liquidity provider tokens (LPs) and liquidity staking tokens (LSTs).

A longstanding challenge

If decentralized finance is ever to compete with centralized exchanges, it needs to provide solutions to its longstanding liquidity issues. The industry is now testing a multitude of different solutions from cross-chain interoperability protocols to liquidity aggregation platforms, as well as decentralized exchange (DEX) protocols that facilitate liquidity sharing across different blockchains.

Over time it will become clearer which of these offerings can defragment the market. Of course, decentralized finance is a big sector, and it could be that multiple solutions will co-exist. After all, the purpose of decentralized finance must surely be to offer customers greater choice than in the centralized sector.