How to scale DeFi trading / improve liquidity in DeFi - The most pressing issues to scale DeFi
GSR provides over $1B of liquidity a day to DeFi markets and over $3.5bn of liquidity a day to the crypto ecosystem. GSR has operated in the cryptocurrency market since 2013, our defi trading team collaborated to discuss some of the most pressing liquidity issues in defi, and the biggest opportunities for protocols.
Capital Efficiency continues to drive LP’ing
The issues that surround capital efficiency are core to improving the liquidity of the defi ecosystem. Some relatively new project features have lead improvements in this area. Uniswap’s implementation of concentrated liquidity ranges which allows liquidity providers to allocate their assets to custom price ranges is a great example of this. Capital goes to where it's needed and is not wasteful.
Additionally, on the issues of composability and aggregation, being able to direct capital from a shared pool to the best opportunities as efficiently as possible is still out of reach. dYdX is arguably the most successful protocol at present with a lot of exciting activity, but it is siloed. Sushi is doing some interesting developments around liquidity pools being used for multiple products at the same time, making it more capital efficient. Distributing capital from a shared pool will open new doors for liquidity providers.
Layer 1 Gas costs still a blocker on Ethereum
Ethereum’s Mainnet, also known as Layer 1, is Ethereum’s main, public blockchain. Layer 2 is the term for solutions designed to help applications scale by handling transactions off Layer 1 while taking advantage of the robust decentralized security model of Mainnet. The power of Layer 2s is starting to show promise in moving away from expensive gas costs of layer 1, opening up better scalability. If we look at dYdX for instance, it provides both a traditional venue where orders can be created and cancelled rapidly. This provides scalability and cheap transactions that are not possible on Layer 1 protocols. This will become even more powerful when implemented for general-purpose.
More Data Services & Providers
A big challenge is surfacing blockchain data in a way where researchers or quant traders can run their back-testing and simulations. Blockchain data is used to help trading simulators validate or reject trading ideas, and it is currently not possible to do at the scale seen in centralised order books. At the moment, there is no simple solution nor data service providers offering a holistic solution and getting this information from the Full Node is extremely inefficient.
More protocol resistance to front running
Due to the transparent nature of the blockchain, maximal extractable value (MEV) gives away information to the market about what size of activity is coming. This is one of the most interesting areas of defi, but also an area that is an unresolved problem. There are some private solutions (FlashBots, Eden Network, bloXroute) to solve this. But protocols themselves should add better resistance to MEV as well in order to prevent front running.
More Security Audits
Protocols need to be battle-tested before market actors feel comfortable partnering or experimenting with them. It is still common for new protocols to emerge that appear to be offering something useful, but do not have the testing to back it up.
Making liquidity stick with incentive structures
Incentive structures have powered the growth of many projects, the most recent example being Avalanche’s Avalanche Rush program. This boosted liquidity from around $200M of total value locked in August to around $8B today. An important question is - will the liquidity stick around when the incentive scheme runs out? Liquidity mining is what has drawn users rapidly to protocols, however sometimes they leave just as quickly. DeFi users are pretty fickle and chase the best yields (see the Sushiswap "vampire attack" on Uniswap.) This often results in short lived success for some protocols and has given rise to protocol-owned liquidity which now aims to solve the issue of longevity. At present Olympus DAO attempts this by securing LP tokens into a protocol in the structure of bonds that maintain liquidity over longer periods.
Further development of cross chain bridging / cross chain LP’ing
Bridge activity - the transfer of tokens and/or arbitrary data between chains - has been increasing lately, both from Ethereum L1 to L2 chains and also between different L1s. Etherscan currently lists 74 bridge contracts. Amongst the first teams to address this challenge is Li.Finance, who posit that cross-chain bridges are likely to play a major role in DeFi enablement. Currently they support cross-chain swap route optimization across EVM compatible L1+ L2 chains including Ethereum, Arbitrum, Optimism, Harmony, BSC, Polygon, xDAI and Phantom, although at the moment swappable tokens are limited to a number of stablecoins.
One of the key challenges for bridging solutions is long exit times and high costs. As a result, the interaction between L2s/rollups and the respective L1 chain can be slow and expensive. Protocols like Connext/NXTP, Nova and Hop aim to offer fast entries and exits by acting as liquidity networks to help mitigate these challenges. Given these bridges are the gateway to high throughput L2s, solving these interoperability and cross-chain liquidity problems are key to blockchain scalability as a whole.
GSR’s unparalleled expertise and experience in the market provides us with the background needed to understand these complex challenges and can help DeFi projects to drive further adoption and usage.
With integrations with major DEXs and service providers across all leading protocols, GSR works with investors, builders and token issuers as an active investor, liquidity provider and infrastructure operator across the DeFi ecosystem. Reach out to firstname.lastname@example.org to collaborate.