Decentralized finance (DeFi) has witnessed a remarkable expansion. The latest downfall of FTX has underlined the importance of a permissionless DeFi ecosystem. The demand and development for on-chain financial products, such as futures, options, and decentralized exchanges have increased. 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.
Current challenges within the DeFi ecosystem
Our research shows that existing DEXs have several design flaws:
Arbitrage – the biggest value drain for the DEX
Whereas traditional market makers benefit from price differences within and across exchanges, generating arbitrage profits, liquidity providers do not participate in arbitrage trading. What users experience as impermanent loss, mostly is a consequence of arbitrage traders taking benefit from pool liquidity provided by liquidity providers.
Manual liquidity management
Liquidity providers must manually identify, manage, and rebalance their liquidity allocations across different pools. In fact, this opportunity cost of managing funds hinders many individuals from participating in the DeFi ecosystem. This process is not only time-consuming and error-prone but also capital-inefficient. Inefficient liquidity management leads to low APY, increased impermanent loss, and inefficient capital markets.
No fair trading
To achieve mass adoption trading at DEXs must be fair. Miner extractable value and liquidity attacks allow trading bots to front-run, sandwich, or attack traders and liquidity providers. Experts who know about it benefit by deploying trading bots, and those who don’t suffer losses.
High price impacts and slippage
As a result of manual liquidity management and fragmented liquidity, 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.
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 increased impermanent loss risks when the price moves outside their chosen range.
In summary, the design flaws and challenges in the current DEX ecosystem contribute to unfair trading, arbitrage value drain, 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 user experience.