What would the DeFi world be like without liquidity wars?
Author: 0xmiddle
Translator: Eason Jiang
Reviewer: Elliot Sayes
Source: Content Guild Translation
Since the inception of DeFi, a relentless liquidity war has been ongoing.
We've seen many DeFi projects pay substantial costs or release a large number of tokens to acquire liquidity. Some projects have succeeded and gained market dominance, such as Uniswap. Others have chosen to avoid direct competition by establishing liquidity advantages in specific asset categories such as Curve with stablecoins and Balancer with LSDs, thereby securing a chance for survival. Many other projects have exhausted their resources and ultimately failed.
Causes of the Liquidity War
DeFi liquidity is an area prone to natural monopolies, meaning liquidity tends to concentrate around leading protocols.
There is a logical chain: DeFi products with more liquidity offer higher usability, attracting more users and therefore more liquidity providers to collect fees. Conversely, if a product has limited liquidity the usability suffers, user numbers decrease along with liquidity providers. This is a clear example of a monopolistic “network” effect.
Because of this effect, the competition for liquidity is extremely fierce. If an DeFi project cannot acquire substantial liquidity—at least in a specific asset category—it will struggle to survive. New DeFi projects aiming to capture liquidity must pay a steep price, often far exceeding their investments in product development and technological innovation. This short-sighted tendency is very unfavorable to innovation and development within the DeFi sector, but it doesn’t have to be.
From Liquidity Wars to Liquidity Sharing
We advocate for a new path: cross-protocol liquidity sharing. Decentralized finance should be open, which is why it is sometimes referred to as Open Finance. We believe that cross-protocol liquidity sharing is a natural progression, and that ecosystems establishing a unified cross-protocol liquidity standard will have several advantages.
First, when liquidity can be shared, DeFi projects no longer need to compete for liquidity to enhance product usability. Even products with less liquidity can offer users access to global liquidity, ensuring their user experience is not compromised. However, the competition for liquidity doesn't disappear entirely, as projects with more liquidity can still capture more transaction fees. Thus, liquidity sharing effectively transforms the monopolistic, winner-takes-all liquidity wars into healthy competition.
Second, when liquidity can be shared, emerging DeFi projects can be bootstrapped without needing to incur the huge cost of acquire a large amount of liquidity. This allows projects to focus their resources and team efforts on truly valuable innovations, such as improving capital efficiency and enhancing matching mechanisms.
Third, by decoupling liquidity from the product‘s front-end projects can adopt more diverse business models. Take decentralized exchanges (DEXs) as an example: when users trade on a DEX platform, the fees they pay include two parts: front-end usage fees and liquidity usage fees. The front-end usage fees go entirely to the platform, while most of the liquidity usage fees go to liquidity providers (LPs), with a small portion going to the platform. This means a DEX platform's revenue can be understood as comprising two parts: front-end usage fees and commissions of liquidity usage fee. Without decoupling, users are restricted to using the liquidity of the project whose front-end they use. With liquidity sharing, users can enjoy global liquidity regardless of which front-end they use. This not only gives users the freedom to choose their front-end, but it allows projects to focus only on building the component that best suits their strengths:
- Platforms with traffic or developers who are capable of creating smooth user experiences can focus on developing the front-end, with front-end usage fees as their main revenue stream. This resembles an aggregator business model, but in the absence of a unified liquidity sharing standard, aggregators need to develop complex routing protocols, where their core competitiveness lies in the intelligence of the routing protocol rather than the front-end.
- Platforms with LP resources and the ability to aggregate more capital can choose to primarily earn commissions of liquidity usage fee, without needing to invest heavily in optimizing the front-end experience. LPs with financial strength and development capabilities can even choose to build their own liquidity platforms, avoiding any commission charges and not needing to entrust their funds to any protocol.
LPs with strategy management capabilities can even customize their market-making strategies on their self-built liquidity platforms, free from the constraints of a unified platform.
| Liquidity Wars | Liquidity Sharing | |
| User Experience | Experiences fragmented liquidity and often has to choose platforms with more concentrated liquidity | Enjoys global liquidity on any platform |
| DeFi Projects | Need to gather substantial resources to acquire liquidity quickly | Can focus on truly valuable innovations |
| DeFi Ecosystem | Projects compete by monopolizing liquidity | Projects can compete both on liquidity and front-end user experience |
FusionFi Protocol
Ending liquidity wars and achieving liquidity fusion is precisely what the FusionFi Protocol (FFP) aims to accomplish within the AO ecosystem, with the goal of a healthier DeFi ecosystem. But how does FFP achieve liquidity fusion?
At the core of all financial operations is the circulation and processing of “orders”. FFP defines a unified order format, that can represent spot orders, options, futures contract orders, and loan orders. Through this single model, FFP has the capability to model any financial scenario.
Take a DEX as an example: anyone can create spot order notes, including AMMs (when a user initiates a trade request, the AMM can also create a temporary limit order). These notes enter an note pool, which anyone can view and extract matching notes from, submitting them to the Settlement Process for execution. Once settled, the note’s status changes, and both parties involved in the trade receive their respective interests.
The settlement of orders is atomic; if it fails, the note’s status remains unchanged, and no actual asset exchange occurs between the parties. It is also highly efficient, allowing for the settlement of individual note or multiple notes simultaneously. Settlement can be submitted by the trader or by anyone else. This provides DEXs with several advantages, such as multi-hop transactions and zero-capital arbitrage.
- Multi-hop transactions refers to situations where a user wants to exchange asset A for asset C but lacks direct liquidity. The user can complete the trade by first exchanging asset A for asset B, then asset B for asset C.
- Zero-capital arbitrage involves an arbitrageur identifying orders with price differences in the order pool and submitting them for settlement to capture the price difference as profit.
Both multi-hop transactions and zero-capital arbitrage essentially involve the joint settlement of multiple notes.
Source: https://x.com/Permaswap/status/1854212032511512992
Alongside these benefits, the FFP SDK allows developers to implement most kinds of DeFi services with minimal code. Just as the Cosmos SDK significantly reduces the time developers need to create blockchains, the FFP SDK greatly reduces the time AO developers need to create DeFi protocols.
Summary
The natural monopoly effect of liquidity leads to fierce liquidity wars among DeFi protocols. This not only results in fragmented liquidity and harms user experience but also causes new protocols to allocate excessive resources to compete for liquidity, preventing them from focusing on truly meaningful innovation.
To address this situation and accelerate the development of the DeFi ecosystem, AO introduced FFP, a unified protocol for cross-project liquidity sharing, from the early stages of ecosystem development. This approach increases the overall liquidity efficiency of the ecosystem and unleashes developers' creativity. With FFP at its core, the AO ecosystem’s DeFi landscape is expected to rapidly build momentum into a major industry player.
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