Decentralized finance (DeFi) has witnessed remarkable expansion, both in terms of product offerings and user adoption. A diverse range of financial products has been deployed across multiple blockchains, characterized by decentralization, high accessibility, and trustless transactions. In 2021, the total value locked (TVL) in DeFi surged to $53.18 billion, a substantial increase from $1.08 billion in the previous year. Concurrently, the Ethereum blockchain's TVL grew by a remarkable 771%. Uniswap, an Ethereum-based decentralized exchange (DEX), is among the most renowned and widely utilized DeFi protocols, boasting a fully diluted market capitalization of $5.8 billion as of July 12th, 2022.
Since the summer of 2021, numerous projects have emerged with enhanced protocols and liquidity pool architectures. These platforms primarily aim to manage liquidity more intelligently, thereby augmenting the annual percentage yield (APY) and mitigating impermanent loss risks, all while refining liquidity providers' overall user experience. Pioneering in the realm of DeFi innovation, these novel protocols have piqued interest in observing their future developments and impact on the rapidly evolving DeFi landscape.
What we realized during market research is that existing DEXs have several design flaws that lead to impermanent loss and low APYs for liquidity providers, and high slippage and price impact for traders:
- 1.50/50 pool architectures: Traditional DEXs often utilize a 50/50 pool structure, which requires liquidity providers to deposit equal parts of both tokens into the pool. This design can expose liquidity providers to higher impermanent loss risks, particularly when the price of one token experiences significant fluctuations.
- 2.Concentrated liquidity: Some DEXs employ concentrated liquidity, where liquidity providers can specify a certain price range for which they want to provide liquidity. While this approach can improve capital efficiency, it also exposes liquidity providers to impermanent loss risks when the price moves outside their chosen range.
- 3.Manual liquidity management: Liquidity providers must manually identify, manage, and rebalance their liquidity allocations across different pools. This process is not only time-consuming and error-prone but also capital inefficient. Inefficient liquidity management can lead to lower APY and increased impermanent loss risks.
- 4.Nonlinear liquidity distribution: The manual management of liquidity allocations results in a nonlinear distribution of liquidity across pools. This uneven distribution can cause significant price impacts and slippage when traders execute large trades at low TVL.
- 5.High price impact and slippage: As a result of the nonlinear liquidity distribution, traders often experience high price impacts and slippage on their trades, leading to financial losses. This situation also creates arbitrage opportunities, causing assets and value to be drained from DeFi protocols.
In summary, the design flaws and challenges in the current DEX ecosystem contribute to impermanent loss risks and low APY for liquidity providers, as well as high slippage and price impact for traders. Despite attempts to address these issues, no existing solution has successfully eliminated losses for both parties. Therefore, there is a pressing need for innovative approaches that can tackle these problems and improve the overall DeFi experience.
Let us explain that in numbers: A 22k USD swap on Orca at 630k USD TVL results in an over 4.5% price impact and 43% of all Uniswap Pools are exposed to impermanent loss, so almost every DeFi user is experiencing this problem.
Looking at the EVM ecosystem, which is the biggest and most innovative DeFi ecosystem, there have been several attempts to address this problem, for example, the projects Curve and Balancer, or Tokemak but no solution succeeded in both aspects – eliminating the liquidity provider’s and trader’s losses.