🔍Background

Latest DeFi developments

Decentralized finance (DeFi) has grown dramatically in terms of product offerings and user uptake. A varied variety of financial products, characterized by decentralization, high accessibility, and trustless transactions, has been deployed across several blockchains. Total value locked (TVL) in DeFi increased to $53.18 billion in 2021, up from $1.08 billion the previous year. Concurrently, the Ethereum blockchain's TVL increased by an astounding 771%. Uniswap, a decentralized exchange (DEX) based on Ethereum, is one of the most well-known and commonly used DeFi protocols, with a fully diluted market value of $5.8 billion as of July 12th, 2022.

Numerous ideas with improved protocols and liquidity pool topologies have developed since the summer of 2021. These systems essentially attempt to manage liquidity more intelligently, hence increasing the annual percentage yield (APY) and minimizing temporary loss risks, all while improving the overall user experience of liquidity providers. These unique protocols, which are pioneering in the domain of DeFi innovation, have spurred curiosity in studying their future advancements and influence on the fast-expanding DeFi ecosystem.

Current challenges within the DeFi space

During market research, we discovered that existing DEXs had various architectural faults that resulted in temporary loss and poor APYs for liquidity providers, as well as excessive slippage and pricing effect for traders:

1. Manual liquidity management: Liquidity providers must identify, maintain, and adjust their liquidity allocations across several pools manually. This method is not only time-consuming and error-prone, but it is also wasteful in terms of capital. Ineffective liquidity management might result in lower APYs and higher temporary loss risks.

2. Concentrated liquidity: Some DEXs use concentrated liquidity, which allows liquidity providers to designate a price range in which they want to supply liquidity. While this technique can enhance capital efficiency, it also exposes liquidity providers to temporary loss risks when the market goes outside of the range they have established.

3. Nonlinear liquidity distribution: Manual liquidity allocation management leads to a nonlinear distribution of liquidity across pools. When traders execute big deals with low TVL, this unequal distribution can result in severe price implications and slippage.

4. 50/50 pool architectures: Traditional DEXs frequently have a 50/50 pool structure, requiring liquidity providers to deposit equal percentages of both tokens into the pool. This arrangement may expose liquidity providers to larger temporary loss risks, especially if the price of one token fluctuates significantly.

5. High price impact and slippage: Traders frequently encounter large price effects and slippage on their trades as a result of the nonlinear liquidity distribution, resulting in financial losses. This circumstance also generates arbitrage possibilities, resulting in the draining of assets and value from DeFi protocols.

In summary, the existing DEX ecosystem's design defects and issues lead to temporary loss risks and poor APY for liquidity providers, as well as excessive slippage and price impact for traders. Despite efforts to address these challenges, no known solution has eradicated losses for both parties. As a result, there is an urgent need for novel technologies that may address these issues while also improving the entire DeFi experience.