Vega, a blockchain project that is building a decentralized protocol to run infrastructure for programmable financial markets, today released its research Market-Based Mechanisms for Incentivising Exchange Liquidity Provision. Low liquidity is a major known problem for decentralized crypto exchanges (DEXs).
In its paper, Vega describes its solution to this problem — mechanisms for creating open, automated, and scalable liquidity markets.
At present, the trade volume of the largest DEX, Uniswap, stands at about $18 million, a far cry from the $1.3 billion in trade activity on the popular centralized exchange Binance. Despite recent surges in decentralized exchange activity, DEXs still only account for less than 1% of all crypto trading. There is a glaring gap in performance between centralized and decentralized exchanges, and liquidity is a significant part of the problem.
A recent survey from Encrybit asked more than 1,000 traders, “What are the biggest problems that you see in currently available exchanges?” Thirty-six percent identified “lack of liquidity” as the most significant issue.
Below is an excerpt from Vega’s latest research:
“A key problem for exchanges is how to attract liquidity providers and retain their support in all market conditions. This is commonly approached through individual business agreements with market makers whereby a bespoke contract is negotiated for specific obligations and rewards. Such approaches require a central intermediary that profits from liquidity provision to administer, and typically fail 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.”
Many DeFi projects have socialized yield farming and liquidity mining as a popular way to bootstrap early liquidity. However, these solutions only offer a short term fix. In the case of DeFi exchanges, rewards rely on allocation of some scarce asset, which ultimately makes yield farming a diminishing incentive for early enthusiasts to keep supplying liquidity.
“Right now, it’s difficult to prove that yield farming can create a stable and long-lasting network effect for DeFi protocols and their governance systems,” said Barney Mannerings, Vega Co-founder. “It is far more likely that the model will create several farm-and-dash situations.”
Vega proposes a novel way to structure liquidity commitments and a mechanism based on a financial bond with penalties for under-provision to maximise market makers’ adherence to their obligations.
The paper explains, “The goal is to set up a market mechanism that optimises the amount of liquidity provision such that liquidity incentives increase when liquidity is under-supplied, and decrease when there is sufficient liquidity in the market. Markets are assumed to potentially have multiple market makers, each of whom can decide which market to supply liquidity to.”
Liquidity incentives are at the core of the Vega protocol. Through its research, the Vega team explores several liquidity scenarios and outlines the process for balancing liquidity incentives to maximize trading efficiency and minimize fees, slippage, and collisions.
According to Token Insight’s 2019 DeFi Industry Annual Research Report, “With the integration of liquidity aggregator and market making bot, DEXs will grow [at] a much faster pace in 2020, however centralised exchanges will still dominate the market.”
Many DEXs have chosen a reactive approach to the liquidity problem. Their systems don’t outright address an economic incentive model, and shared liquidity pools are subject to opportunistic manipulations. The lack of auto-balanced obligations and rewards create conflict and adversarial relationships between exchanges that exist to the detriment of both traders and liquidity providers.
Still, there is a need to aggregate liquidity for DEXs in a fair and rewarding manner. Without a strong liquidity base, DEXs will never rise to mainstream adoption.