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Decentralized exchanges have a liquidity problem. Is this the answer?

The Vega protocol is proposing a mechanism that incentivizes market makers—but only when liquidity is undersupplied

Low liquidity is a common problem on decentralized exchanges—and now, a blockchain project has claimed it has a solution.

Vega’s proposal involves setting up a mechanism that increases incentives for market makers when liquidity is undersupplied, and decreases when there is sufficient liquidity—that is, the ability to execute buy and sell orders quickly.

A decentralized exchange focused on derivatives, Vega released a report on July 8 setting out the challenges facing DEXs in no uncertain terms. Figures show trading volumes at Uniswap, the world’s largest DEX, stand at about $18 million—a country mile from the $1.3 billion seen on centralized platforms such as Binance.

And this massive divide comes as decentralized finance enjoys a spike in popularity. According to Vega, there is a “glaring gap” in performance between the Uniswaps and Binances of this world, with liquidity “a significant part of the problem.” Indeed, the project cited research that shows 36% of traders say a lack of liquidity is the biggest issue they experience on exchanges.

While lack of liquidity is troublesome in spot markets, it is an especially severe problem in derivatives markets. Without sufficient liquidity, the ability to liquidate an insolvent participant’s position is threatened, in turn endangering the counterparty’s position.

The lack of liquidity in cryptocurrency markets has been one of the barriers to attracting large institutional clients, according to Huobi Group. It launched Huobi Brokerage at the beginning of the year. Among the features offered are liquidity pools.

The battle for liquidity

Vega’s research said attracting liquidity providers and retaining their support in all market conditions has been a major headache for exchanges. A common solution has been to strike up individual business agreements with market makers, with bespoke contracts negotiated for specific obligations and rewards.

But Vega’s report said: “Such approaches require a central intermediary that profits from liquidity provision to administer, and typically fails to align the incentives of exchanges and liquidity providers as markets grow. This is costly, slow, and scalability is limited by the exchange’s resources, contacts, and expertise.”

Decentralized Finance projects haven’t been immune from these challenges. Yield farming and liquidity mining are often used by DeFi firms in early stages, but Vega described these approaches as a “short-term fix”.

Barney Mannerings, the co-founder of Vega, said: “Right now, we are seeing an explosion of interest in DeFi and liquidity incentivization, however much of the current activity is fueled by unsustainable handouts rather than fundamental advances.

“It’s too early to tell which approaches will succeed and which will fail, but there’s precious little rigorous research into the measurement and pricing of liquidity and the resulting mechanism design.”

Driving DEXs

Vega also pointed to research from Token Insight that suggested “centralized exchanges will still dominate the market” even as DEXs begin to grow at a faster pace.

The blockchain project argues that DeFi platforms can only scale and be competitive with traditional markets if liquidity incentives are automated at the protocol layer.

“To date, DEXs have not demonstrated sustainable and scalable liquidity solutions and have either ignored the problem and suffered from a ‘graveyard’ of illiquid markets, or attempted solutions that don’t scale or adapt to the market demand for liquidity. Vega’s ‘liquidity markets’ designs a new approach to matching liquidity providers with trading demand in a scalable and sustainable way,” according to a release.

Vega recently launched a Markets and Liquidity Program with seven founding members to explore some of these ideas further. Community-led proposals are being developed for the first liquid markets on Vega’s mainnet alpha release, which is due to take place later in 2020.

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Connor Sephton is a journalist with an interest in cryptocurrencies, personal finance, and financial inclusion—as well as the challenges the crypto industry faces in achieving mainstream adoption. He owns cryptocurrencies.