In the introductory article, “Beginners Guide To Shared Liquidity,” we discussed the basics of Shared Liquidity, its benefits, and challenges.
But these ideas could change the way we conceive DeFi, forever. Let’s dive in!
Who Needs Shared Liquidity and Why?
Table of Contents
The obvious answer to the question of who needs shared liquidity is AMMs. But is it really true? We know that AMMs have been experiencing liquidity bootstrap issues in the past. The fragmented liquidity models could not solve the problem of availability and accessibility, which should have been paramount.
Although Uniswap V3 brought changes to the concept of liquidity and pooling by introducing concentrated liquidity, it eventually concentrated the available liquidity into tighter price ranges. It contributed to massive liquidity flow into Uniswap pools.
Source: https://info.uniswap.org/#/ (Data for Ethereum Network)
According to Uniswap data, the TVL of the platform grew from $139M to $3.22B in 26 months.
However, the $UNI token could not benefit from the TVL expansion, as it plunged from $40 to $5.5 during the period. This is largely due to harsh market conditions and token vestings.
Source: CoinGecko
The later efforts on Shared Liquidity were around increasing the accessibility and availability. A notable project that shifted its focus into Shared and Cross-chain liquidity was Injective Protocol.
After announcing the Shared Liquidity pool in August 2022, Injective’s growth was massive. In less than 10 months, $INJ exploded from $1.8 to $8.77.
Source: CoinGecko
It is crucial to notice the change in narratives from 2021 to 2022, from concentrated liquidity to cross-chain liquidity. While in 2023, the narrative is shared liquidity.
Uniswap was crowned winner in 2021, it was Injective’s turn in 2022, and SEI has its stakes in 2023.
Sei Network builds around the concept of shared liquidity and aims to supply liquidity to multiple dapps simultaneously. The concept has attracted major VCs such as Coinbase Ventures into investing in Sei, and the project has received a total of $85 million from various rounds. Moreover, SEI is valued at a whopping $800 million at the time of writing. Clearly, the smart money is pursuing shared liquidity, and somehow, it just feels like a beginning.
It pushes us back to the question of who needs shared liquidity. Not just AMMs, not just DEXs, the whole crypto defi ecosystem is rooting for it, rather silently, at least for now.
So, why is smart money chasing shared liquidity?
The monopoly of Curve as the industry-leading liquidity pool is rather overlooked. In January 2022, Curve held 8.6 M ETH in TVL. The first hit was the depeg of $MIM, a yield-bearing stablecoin by Abdacadabra.money.
Source: Dune
The situation was further demystified in the UST crash and subsequent depeg of stETH. Simply, the system had a deep single point of failure. When multiple projects started using Curve as the base layer for stablecoin swaps, the protocol dependency went through the roof. We all know how the UST situation has impacted the market and wiped off around $18 billion from the crypto marketcap.
The problems with Curve did not stop there. The voting system turned into a preplanned attack system that targeted specific pools for maximum money extraction. Curve wars for steering incentives became commonplace, and each protocol offered insane incentives to bribe voters into choosing their protocol to steer liquidity.
When the protocol gets to offer the maximum rewards, it witnesses massive liquidity inflow. This precipitated the fall of defi tokens and insane inflation levels. The whole system around Curve became a money printer with a non-functioning break and an overleveraging engine.
System Is Broken
Any defi enthusiast would fondly recollect the OHM period (Olympus). Times when 10000% APRs were normal, and each OHM fork grew in size before collapsing. What OHM displayed as a successful strategy to attract users and liquidity: offering crazy high incentives. It became a playbook 101 for other sectors too. The result? Defi became a degen affair, a little more than it should be.
Even today, a lot of pools offer high APRs for liquidity providers. The chase for APRs created insignificant pools with little to no utility. Take a look at FLOW-SOMM pool that offers 1230% APR. It launched with 137635% APR on March 29, 2023. Now, the TVL remains at $14,167, with little to no activity.
Source: Beefy Finance
The argument is not that high APR pools are not necessary; of course, they play a significant part in bringing new liquidity. But the burden of incentives shall not kill small yet innovative protocols which actually wish to create a useful native token with better tokenomics.
When smart money identified this problem, they began searching for solutions that could optimize liquidity and potentially provide a better defi experience. Meanwhile, cross-chain liquidity led to an increase in bridge hacks in 2022, where Ronin, Wormhole, Nomad, and Harmony bridges serve as examples.
Source: Data from cryptosec
The solution was to ‘trap’ the active liquidity (that arose from concentrated liquidity) into multiple pools to service multiple protocols. Low-slippage transactions were a mutually beneficial end goal to pursue with full force.
But what crypto actually require is network-level ‘omnipresent liquidity.’ It means smart-contract-controlled liquidity pools that exist as multi-chain and behave as single-chain ecosystems. It is not aggregation nor cross bridging, but a 1:1 copy of pooled tokens in all chains, overseen by a burn mechanism to prevent fake liquidity.
A user should be able to swap $USDC in Ethereum to $BNB in Binance Smart Chain without bridging or paying a hefty Ethereum gas fee. It is quite possible to execute in P2P trading as there is mutual demand for liquidity. But the time dependency of such transactions can impact the overall user experience.
As blockchains are conceived as state machines with state dependency, transactions or blocks can only move from their initial state (initiation/paying the gas fee) to the final state (completion).
σ(t+1)=Υ(t,t+1)(σt,Tt,t+1)
So a liquidity pool can not collect partial liquidity from multiple users and proceed as a single liquidity pool. Perhaps this is the biggest constraint defi might face in the coming years.
That means a protocol can not collect 1 ETH from user A who wants to convert his ETH to USDT in Tron Network and collect 500 USDT from user B who wants to swap from the Tron network to an ERC-20 token on the Ethereum network and proceed with the partial transaction.
While it is executable at a smart-contract level at some point, a protocol-level or network-level execution requires even more innovation. Probably shared liquidity is the path we need to embrace in this evolutionary transition of defi.
Is Development A Liability For Sustainable Liquidity?
Recently, rollup solutions in Ethereum exploded and are actively battling for users, volume and liquidity. The easy solution was facilitating wash trading by offering massive airdrops for high-volume users. But each of these rollups contributed to liquidity fragmentation at a network level.
However, new chains should not hinder defi but rather create avenues for increasing and bootstrapping the available liquidity.
One such solution is SLAMM (Shared Liquidity AMM).
SLAMM is a novel mechanism that can solve liquidity fragmentation using a coordinating appchain Hub, virtual liquidity pools, and “satellite” deployments on other chains.
SLAMM enables LPs to deposit one LP for all chains and even collect fees across all the chains in native coins and share of the pool. Currently, SLAMM is achievable in Cosmos with its interchain hub, but it’s just a matter of time until we see SLAMMs in other networks too.
Even though the virtual liquidity by SLAMM can provide better and augmented pricing, it also increases impermanent loss, which is yet another milestone to conquer for developers.
Here, the Hub does not move real tokens or liquidity (thus, a smart contract hack is less risky), but instead, it alters liquidity on multiple chains simultaneously. It also does not run into problems involving duplicated liquidity, as the virtual increase in one chain is balanced with a virtual decrease in another. These virtual LP tokens are the backbone of maintaining the security of SLAMM.
Nevertheless, the SLAMM model is not the perfect solution as two risks are associated. One, the satellite chain can halt; and two, the Cosmos hub can halt. Although the latter is quite unlikely, such an event can be detrimental to liquidity providers as the Hub keeps track of the shared liquidity across networks.
Conclusion
Web3 is moving towards a multi-chain future. Numerous L2s on Ethereum, upcoming Modular chains, and other L1s point in the same direction. A multichain future can only be possible with multifaceted interoperability.
Shared liquidity is the interoperable defi. As new chains emerge, liquidity fragmentation will cause another race for liquidity and over-incentivization. Only cross-chain or multi-chain liquidity provisioning can break this loop and elevate defi to new heights.
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