What is Web3

Web3 represents a paradigm in an equitable and user-driven financial system, where participants have great financial control and can access a wide range of financial services without any third party. DeFi is a component of web3 that leverages the power of the blockchain and crypto-economics to provide faster, more accessible, and user-friendly financial services.

In a nutshell, it is a decentralized, user-driven internet where financial services are accessible and secure for everyone.

The advent of programmable blockchains happened in 2014 when Vitalik Buterin envisioned a platform that went beyond the basic capabilities of bitcoin to enable the creation of decentralized apps and smart contracts known as Ethereum. Since its inception, it has become the largest platform for building decentralized applications and is recognized today as the foundation of the DeFi ecosystem with over $ 45 billion in value.

What is Ethereum?

Ethereum is a decentralized open-source blockchain that provides the infrastructure and environment for DeFi protocols and services, allowing for the creation of decentralized applications that can interact with each other and enable a new and user-driven financial system.

It addresses the limitations of some existing blockchain technologies, primarily bitcoin, and to do more:

1. Self-executing and autonomous computing

2. Creation of digital assets

3. Creation of decentralized applications and services.

4. Self-sovereign financial systems.

5. Turing complete.

It had two main layers; The execution and the consensus layer.

The Execution Layer:

The execution layer is a substack of the Ethereum network layer that handles transaction exchange in the Ethereum peer-to-peer to network, internal communication, and executing the transactions in batches while communicating in parallel with the consensus layer for the propagation and finalization of these transactions.

But what are these transactions?

Transactions in Ethereum are what compose the Ethereum state. Think of it as the data to be saved in a database. In Ethereum, such data are cryptographically encrypted entities that modify/change the Ethereum state from A(previous) to B(new).

A simple example of an Ethereum transaction is sending crypto (ETH) from Alice to Bob. This single action modifies the state of Ethereum permanently.

DeFi Primitives

Decentralized Finance (DeFi) is the financial system built on-chain (blockchain) to provide financial services like lending and borrowing, insurance, trading, asset management, etc. But without relying on traditional intermediaries like banks. It is to be pseudonymous and open to all. All transactions happen on-chain making it transparent and secure. Let us have it in our minds as the User-driven, transparent financial system. The self-custodial version of banking. Some of the DeFi products range from:

Automated Market Makers (AMM)

Automated market makers are a core component of DeFi and are a type of Decentralised Exchange that rely on mathematical algorithms and do not rely on order books to match buyers and sellers. They determine the price of assets mathematically based on supply and demand.

Popular AMMs like uniswap and sushiswap use a pool of assets to back trades to ensure market stability.

Lending and Borrowing

Lending is another core component of Decentralized Finance that involves lending your digital assets to others in exchange for interest. The interest rate is calculated based on demand and supply. Lending in DeFi is very similar to traditional lending. However, borrowing requires over-collateralization in most cases. In protocols like Aave, you will stake a big fish to take a small fish. If you don't return the small fish, you lose the big fish. If your big fish gets thin, you lose it.

Synthetics and Derivatives

Unlike AMMs, where users trade with real-world assets, they are financial products that allow users to speculate asset price movements. Synthetics emulate the price of a real-world asset. A derivative derives its price from a real-world asset. Synthetix is a popular synthetic exchange, and Perp is a derivative market.

Liquidity Mining (yields)

Liquidity mining in DeFi is a way to incentivize users to deposit their assets as liquidity to decentralized protocols. In return, they receive rewards in the form of tokens which can appreciate. In a basic form, it refers to yield Farming. Most Decentralised Exchanges are liquidity farms.

DeFi Today

DeFi has gone through several challenges. From millions lost to several hacks targeting bridges and smart contracts to censorship and OFAC sanctions. one may ask, is DeFi mature yet? In 2022, the crypto market met massive crypto selloffs, FTX collapsed and affected Solana, UST collapsed, taking the Terra ecosystem down Etc. Yet there are bubbling developments, innovations, new financial platforms and instruments, DAOs Etc. The ecosystem kept growing. No, it is not hype.

Let us see some of the popular DeFi projects

• Aave - Aave is a decentralized finance protocol

• Uniswap - an automated market maker

• Balancer - a liquidity protocol

• Curve - decentralized liquidity trading pool

Much more exists, and more innovations are birth in the DeFi ecosystem. However, the platforms and financial markets are scattered in different blockchains, each developing its DeFi product and telling us why it is better while individually encapsulating its liquidity. We can agree that DeFi is fragmented. But what is fragmentation?

Fragmentation

Liquidity fragmentation is a phenomenon where traders have access to different prices for the same financial asset due to multiple trading venues like Exchanges that offer varying levels of liquidity.

But how does it apply to DeFi?

In DeFi, it is synonymous with the division of labor. Liquidity is divided across different decentralized platforms and protocols, making it difficult for traders to access liquidity for a given asset and can lead to price discrepancies between platforms;

There may not have been flashLoans without fragmentation

There may not have been arbitrage trading opportunities without fragmentation

And there may not have been a concept of maximal extractable value (Mev) if thin liquidity markets did not exist.

But it does.

So how does it affect Traders and Investors?

Positively and negatively

1. Bigger earning opportunities, Bigger loss with flash loans - flash loans are used for certain transactions that can exploit price discrepancies between different exchanges or execute complex financial strategies that require short-term liquidity. Also known as instant loans, borrowers take out a loan without putting up any collateral. Only to pay it back before the blockchain includes the transaction.

2. Safer earning opportunities, less risky loss with arbi-trading - Arbitrage trading is a type of trading that takes advantage of price differences in different markets to generate profits. The trader buys an asset in one market where the price is low and then sells it in another market where the price is higher, earning risk-free profit.

3. Maximal crying opportunities with Mev, more money for the miners - MEV is the profit a block producer can earn through their ability to arbitrarily add, remove, or rearrange transactions within the blocks they produce. A miner can change the price of an asset by creating more demand or supply and executing his order ahead of someone else in a low liquidity market.

The proliferation of DeFi protocols

The rapid increase in the number of platforms and protocols in the DeFi ecosystem is one reason for liquidity fragmentation because different platforms and protocols tend to have their pools of liquidity and their prices for the same assets, making it hard for traders to access all available liquidity leading to inefficiencies and increased trading costs.

Current developments

Decentralized Finance is just getting started. The derivative market alone is estimated to be over $ 180 billion. And there are new innovations from talented teams to mitigate the effect of isolated liquidity structures, which includes

1. Cross-chain trading protocols - Enables the trading of tokens across different blockchains and non-custodial liquidity provisions, eliminating the need for bridges and wrapped assets. An example is the Maya protocol.

2. More Efficient relayers - Relay Bridges enable interoperable token transfer, and digital asset transfers between two different platforms, helping bridge the most fragmented DeFi liquidity space. For example, Relaychain.

3. Liquidity aggregators - Gather buy and sell orders from multiple sources and direct them to an executing party. For example, Orion Protocol.

Conclusion

Decentralized Finance has performed impressively over its short period of existence, and a lot of development is still happening in the space, notably with Layer 2 solutions. However, This article highlights liquidity fragmentation, how it applies to DeFi, how it affects users, and some innovations championing defragmentation.

Further Reading