Insight on Liquidity from DeFi Protocols

Published at: April 2, 2020

Over the last year and a half, decentralized finance has had an explosion of activity. Lending and borrowing decentralized applications, margin trading, liquidity protocols, stablecoins, insurance and derivatives have all grown in user numbers, in on-chain activity and in product maturity. As DeFi has grown, the need to exchange value from one form to another has grown with it, and multiple liquidity providers have stepped up to service this growing need for liquidity. This is the natural evolution of any system, introducing expanding functionality and connectivity and as it grows.

Based on our own experience, we wanted to share some insights into decentralized markets and how to scale up to meet DeFi’s growing demands. We feel it’s an important lesson in building a sustainable, growth-oriented future for DeFi.

Efficient use of token inventory

There are multiple ways to bring liquidity to the market. Some liquidity providers use an automated market-making model that uses a predetermined curve to arrive at price discovery, while more manual models include liquidity providers actively rebalancing inventory using multiple sources of liquidity from centralized exchanges and other sources.

Automated market makers, or AMMs, are a great hands-off, open and permissionless approach, with Uniswap — a fully decentralized protocol for automated liquidity provision based on Ethereum — serving as one example. One notable downside to this approach is that tokens can end up being “priced to infinity” (on the extreme edges of the curve), meaning a portion of the token inventory locked up is being inefficiently allocated to price points that are not required by the market and are highly unlikely to be hit in the short term.

Our approach to scaling goes through combining multiple different market maker types under one platform. We cater to automated market-making by providing a very capital-efficient AMM model that allows for setting specific self-stipulated price ranges, while in parallel allowing manual market makers to also plug their liquidity into the platform. This increased competition between market makers, and an improved AMM model, allows for existing inventory to be used more efficiently and we’re therefore able to facilitate more volume than other liquidity providers for the same inventory size. This approach helps scale up liquidity, especially in volatile times such as those seen during Black Thursday’s huge price drops. While some market makers backed off in the face of large price movements that day, Kyber kept providing liquidity due to redundancies that come from pulling in liquidity from multiple market makers.

Exposure to the DeFi ecosystem

It’s been encouraging to see that the required liquidity coming from the demand side — i.e., DApps and their users — has congregated mostly around on-chain price discovery and execution models as opposed to hybrid and off-chain models. This is mostly due to the ease with which different financial primitives can be composed and put together completely on-chain to provide new services, even though hybrid and off-chain models can have a speed advantage during trade execution.

Liquidity in on-chain models can easily be slotted into complex DeFi workflows that include various borrowing, lending and margin trading products. On-chain transparency allows for increased ecosystemwide confidence in the technical viability of what DeFi projects are building, although this is not to say DeFi systems don’t occasionally stumble due to bugs or protocol-level constraints and risks. A lot of the volume and trade activity growth within the Ethereum ecosystem has come from fully on-chain liquidity providers like Oasis, Uniswap and Kyber.

Market making ability and incentives

Correct incentive design is crucial to bringing both liquidity providers and liquidity takers to the table, and incorrectly calibrated incentives can suppress growth due to increased cost and friction at the point of exchange. Most decentralized liquidity providers have opted for a taker-fee model where the taker side — i.e., the end-user — pays a small fee that is then split between the market maker and the protocol itself. This calibration has evolved, of course, as providers have grown in strength and diversity. Still, there’s an opportunity for leaps forward, and Kyber’s Katalyst will provide a new model of incentive design centered around Kyber Network Crystal (KNC) holders governing fee parameters.

Toward the single liquidity endpoint for DeFi

We have come a long way from the early days of DeFi when liquidity levels were low and inventory siloed. Today’s DeFi landscape is a vibrant and thriving one with DeFi DApps interconnected with each other to create unique value chains and exciting new products. Decentralized finance requires decentralized liquidity, and as a result, on-chain liquidity providers have seen the strongest demand in their liquidity solutions. We expect the DeFi space to keep growing in leaps and bounds for the foreseeable future, and fueling that growth will involve more efficiencies, better connectivity and innovative incentives.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Deniz Omer is the head of ecosystem growth at Kyber Network and the founder of Cryptodyssey Capital and ICODueDiligience.com. He has a Master of Science in digital currency from the University of Nicosia.