DeFi represents an exciting and innovative approach to blockchain technology. It can democratize access to financial services and give individuals more control over the investment process by providing a decentralized, transparent, and automated way to manage assets. But as with any immature capital markets system, DeFi faces a common set of well-known and researched problems.
Overall, there are two common problems:
- Fragmentation of liquidity across chains (Ethereum, BSC, Polygon, Arbitrum).
- Fragmentation of liquidity across protocols (Aave, Uniswap, Curve).
Liquidity Fragmentation
Let’s compare CEX and DEX volumes. We can see that most CEX volume is spread among ten exchanges. In DeFi, it is nowhere near that. There are two layers of fragmentation in DeFi:
- Blockchain-level fragmentation
- DEX/Protocol-level fragmentation
Blockchain-level fragmentation refers to liquidity spread across various blockchains: Ethereum, BSC, Polygon, Solana, and many more.
Inside each blockchain protocol, there are many DEXs; on Ethereum, for example, we have Uniswap, Curve, Sushiswap, Balancer, and many more. It is called DEX-level fragmentation.
Furthermore, in a CEX, one can trade derivatives and spot (Binance, ByBit, OKX, etc.). In the DeFi space, we can see separate venues for different asset classes:
- Uniswap/Pancake Swap for general spot trading. Curve best suits swapping assets with relatively the same exchange rate (stablecoins, stETH/ETH, etc.)
- DYDX, GMX, Perpetual Protocol for perpetual futures trading.
- AAVE, Compound for lending/staking.
- Various platforms for options, delta-neutrals LPs, and many more.
As a result, the ecosystem of assets in DeFi is extensive and diverse. Simply selling wETH for USDT can be completed in many ways. Hence the fragmentation of liquidity — a situation in which the liquidity of a particular financial asset or market is spread across multiple different exchanges or platforms. This fragmentation can make it more difficult for buyers and sellers to find each other, potentially leading to higher transaction costs, market impact, and slippage. Liquidity fragmentation can also make it difficult for market participants to get a clear market overview, with the prices and relevant information split across various exchanges.
It is interesting to know that liquidity fragmentation is an established problem. It was identified in young and immature traditional capital markets years ago.
Most DeFi traders operate on different blockchains and face the consequences of blockchain-level liquidity fragmentation every day. Let’s assume an opportunity was identified to put your wETH in a liquidity pool on PancakeSwap with a high APY. However, these assets are on a Polygon blockchain. The result is that a trader needs to transfer (bridge) assets from Polygon to BSC to execute a trade or use cross-chain swaps, which didn’t get mass adoption yet.
Bridging is the process of transferring assets between different blockchain networks. It is useful in cases where the same type of asset exists on multiple blockchains, and a user wants to move the asset from one chain to another. For example, if a user has a token on the Ethereum blockchain and wants to use it on the Solana blockchain, a bridge can be used to transfer the token. Bridging leads to an increase of liquidity for a particular asset and makes it more accessible to users on different blockchain networks.
Blockchain-level fragmentation also leads to less efficient capital and leverage utilization. Well-known lending protocols AAVE or Compound provide leverage using the user’s assets as collateral within one blockchain. This results in the inability to take leverage on the Ethereum protocol using collateral from BSC.
The same thing applies to DEX fragmentation. One can not use Uniswap position as collateral to get leverage on AAVE/Compound and other lending protocols even within the same blockchain. While in traditional financial markets, using one position and its revenue stream as collateral for opening the other is a widespread and well-adopted operation.
To sum up, there are 3 big consequences of liquidity fragmentation:
- Inefficient execution: one needs to use bridging/cross-chain swaps to execute operations on different protocols.
- Cross-chain collateral does not apply to the biggest lending protocols.
- One cannot use active trading positions and their proceedings as collateral.
How does Arkis tackles liquidity fragmentation?
Arkis comprises two products: Arkis Protocol and Arkis Margin Engine.
Arkis Protocol implements cross-chain undercollateralized leverage provision powered by Arkis Margin Engine.
Users can lock their liquidity in Arkis Protocol liquidity pools (Suppliers) to passively earn interest on their tokens while others can borrow funds from pools to trade with leverage in DeFi (Borrowers).
Our margin engine is a centralized portfolio analytics system that calculates the initial and maintenance margin needed to provide leverage to a user. Most importantly, the risk is calculated on a portfolio level rather than segregated. What does it mean for a trader?
Suppose a trader has a long position in wETH on BSC and short perpetual on ETH on Perpetuals Protocol. In that case, his total portfolio risk is relatively low because these positions offset each other. As a result, a trader can get much more leverage for these operations than when a trader has a single long or short position.
Using Arkis Protocol, a user can get cross-chain leverage on various protocols with much lower LTV than traditional credit protocols. How is it possible?
The way prime brokers provide leverage and banks offer credit to their clients is extremely different, even in the traditional finance space. Why so?
Prime brokers provide leverage for specific trading and investment operations and consider asset management industry specifics. As a result, their clients can get x5, x20, and sometimes even x100 leverage if needed. Arkis follows the same route here. Taking leverage on our platform is different from Compound or AAVE in the same way as taking leverage for trading in Goldman Sachs is different compared to opening a credit line in a commercial bank.
The beauty of DeFi is its complete transparency. As a result, new primitives, approaches, and new, unknown to traditional finance and asset classes can be created and deployed. But still, from an asset management perspective, Web3 space is far from its maturity.
At Arkis, we believe there are so many wonderful things to happen soon in the space, but first, we need to build a solid asset management foundation like traditional finance did in the past.
Our team of financial professionals, engineers, algorithmic traders, and blockchain enthusiasts is here to bring DeFi markets to a completely new maturity level.
About Arkis
Arkis — DeFi Prime Broker offers multichain, undercollateralized leverage powered by portfolio margin. Author Oleksandr Proskurin is the Co-founder and Chief Product Officer.
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