What is Liquidity Fragmentation and How Do We Solve It?

Liquidity fragmentation is a significant problem in many financial markets.

While it also affects the traditional financial industry, liquidity fragmentation in crypto is an especially significant challenge facing decentralized finance platforms. 

Fortunately, emerging technological solutions are helping mitigate this problem in the crypto market. 

Here’s how.

What is Liquidity Fragmentation?

Liquidity fragmentation refers to available liquidity in a market being spread across multiple venues, rather than being easily accessible through a single centralized marketplace.

Traditionally, people and businesses traded at a comparatively small number of venues. However, regulation designed to introduce competition and the rise of alternative trading venues have opened up the ways in which trading takes place in the world today. As a consequence, access to liquidity can be fragmented across multiple venues.

In particular, dark pools, alternative trading systems, and other off-exchange venues have complicated the ways in which liquidity is accessed in traditional finance markets.

Liquidity fragmentation can have a range of consequences, including making it more difficult to execute trades and some assets even experiencing increased price volatility.

Liquidity Fragmentation in Crypto

While liquidity fragmentation is also an issue in traditional markets, liquidity fragmentation in crypto is an especially significant concern due to the decentralized nature of the landscape. 

Fragmented liquidity can have significant consequences when it comes to trading and even the broader viability of blockchain projects.

While fears of liquidity fragmentation certainly existed back when Bitcoin was the only dominant cryptocurrency, they have been compounded by the sheer number of different chains that now exist in the world of decentralized finance.

Today, while there is significantly more value moving around the crypto market, the landscape is also rife with more cryptocurrencies and platforms through which those cryptocurrencies can be traded. As a result, liquidity pools can end up being split across multiple sources.

Without adequate solutions, liquidity fragmentation in crypto can make it more difficult to complete trades—especially between less common trading pairs. 

Since there is no centralized authority that determines the value of digital assets, it can also result in volatility and price disparities in the market that can be exploited. 

When it comes to the viability of emerging projects in the crypto market, access to liquidity can even be a ‘make or break’ factor. Without enough liquidity, projects are unlikely to receive the adoption they need in order to survive. 

As we know from applying Metcalfe’s Law to the crypto market, projects require significant user adoption in order to be successful.

Liquidity Fragmentation on Decentralized Exchanges

Liquidity fragmentation on decentralized exchanges is a significant issue; it can cause inconsistent prices between exchanges, high fees and transaction costs, and weaken the decentralized finance landscape.

When users buy and sell cryptocurrencies on a decentralized exchange (DEX), their trades are carried out through smart contracts. In order for trades to be completed in a practical timeframe, however, users rely on their chosen DEX having access to sufficient liquidity.

With the world of decentralized finance having grown into a multi-billion dollar industry, there are a huge number of different DeFi protocols and decentralized exchanges operating in the crypto market. Since liquidity is not centralized, these exchanges have their own liquidity pools. As a result, liquidity can become fragmented across different DEXs.

Another factor contributing to liquidity fragmentation is transaction costs. In a recent paper authored by Lehar, Parlour, and Zoican, they claim that high gas costs on the Ethereum network are one factor promoting liquidity fragmentation on decentralized exchanges. 

Fragmented liquidity has a range of negative impacts on decentralized exchanges and the people who rely on them to carry out their trades. For instance, not being able to complete a trade in a timely manner can result in missing out on being able to buy or sell an asset at a lucrative price point.

When DEXs do not have access to sufficient liquidity pools, users may also have to pay high fees in order to have their transaction prioritized by network participants. Further, when one decentralized exchange does not have enough liquidity, users may have to split up their trades across multiple DEXs—potentially increasing their overall transaction costs.

Solutions for Liquidity Fragmentation

Fortunately, innovators in the cryptocurrency industry have been proactive in creating solutions to address the issues associated with fragmented liquidity. 

A few popular solutions to the issues caused by liquidity fragmentation in crypto are DEX aggregators, blockchain oracles, and cross-chain bridges.

DEX aggregators

DEX aggregators serve as a way to address liquidity fragmentation on decentralized exchanges. They consolidate liquidity between multiple independent exchanges, enhancing the overall liquidity available to decentralized exchanges and their users.

Decentralized exchange aggregators can benefit crypto projects and traders in multiple ways, including by reducing slippage and price impact.

Blockchain oracles

Oracles are another crucial solution, helping to address the consequences of liquidity fragmentation in crypto in a few key ways. As the price of cryptocurrencies can differ between different decentralized exchanges, oracles being able to aggregate prices from a variety of sources into a single feed can reduce price disparity in the crypto market. 

In turn, oracles can mitigate the risk of people attempting to exploit price differences between different exchanges.

At the same time, cross-chain oracles can allow for interoperability between chains that would otherwise be largely unable to communicate with one another. This communication between different DeFi protocols is especially beneficial for cryptocurrencies that do not yet have their own significant user base.

Cross-chain brides

Bridges enable the trade of assets between different blockchains in the crypto market. Without cross-chain bridges, assets with smaller liquidity pools may have trouble interacting with cryptocurrencies that use other protocols and would especially be left fending for themselves on their own isolated island. 

Since the cryptocurrency industry is now made up of so many different projects, having a way to trade between different cryptocurrencies provides access to cross-chain liquidity. In other words, even assets with smaller liquidity pools can allow their users to complete trades thanks to the existence of bridges. 

As a result, cross-chain bridges are a fundamental way to overcome the issues associated with fragmented liquidity. 

The Bottom Line

Liquidity fragmentation in crypto and on decentralized exchanges is an ongoing issue—much as it is in the traditional financial market as well. 

Fortunately, solutions such as DEX aggregators, blockchain oracles, and cross-chain bridges are helping address the challenges associated with fragmented liquidity. 

While these are just three core examples of how the issue is being addressed in the crypto market today, they illustrate the decentralized finance industry’s broader ability to overcome major hurdles as the landscape continues to mature.