Solving the Liquidity Challenge of Decentralized Exchanges

Entrepreneur Loi Luu discusses why he believes liquidity is a key challenge keeping decentralized exchanges from going from concept to production.

AccessTimeIconAug 13, 2017 at 11:00 a.m. UTC
Updated Sep 13, 2021 at 6:49 a.m. UTC

Loi Luu is the co-founder and CEO ofKyberNetwork, a decentralized, trustless, cryptocurrency exchange. 

In this opinion piece, Luu discusses the challenges facing technologists seeking to popularize decentralized exchanges for cryptocurrency trading, framing liquidity as one of the key obstacles to production.

The total market capitalization of cryptocurrencies is now above $137 billion, up from $16 billion at the beginning of the year.

But before the world can conduct a significant amount of its transactions via cryptocurrency markets, the problem of liquidity must be addressed.

Liquidity refers to the extent to which a market allows assets to be bought and sold at stable prices. Lower liquidity tends to result in a more volatile market (especially when large orders are placed), and it causes prices to change more drastically; whereas higher liquidity creates a less volatile market, and prices do not fluctuate as significantly.

Today, cash is the most liquid asset. If a transaction of $1 million takes place, the market is able to absorb that transaction easily without the value of the dollar drastically changing. Costs associated with the transaction, and the value of the currency at the time of the transaction, are also known beforehand.

However, the same transaction in bitcoin, or any other cryptocurrency, has a much greater effect on the cryptocurrency's value.

This is because of the market's lack of liquidity. The amount of cryptocurrency available on a specific trading platform can run out, requiring the buyer to complete the transaction at 1–10 percent more than expected.

To complete the same transaction of $1 million, it could end up costing between $10,000 and $100,000 more than the original price to make the trade.

Decentralized trading platforms

Until now, the cryptocurrency space has been dominated by centralized exchanges that help facilitate transaction from government currencies to cryptocurrencies.

Centralized exchanges, like Coinbase, are easy to access and easy to use. However, as many have failed to adequately secure their customers' funds, decentralized exchanges are becoming a popular concept.

Centralized exchanges have been simply unprepared for the recent influx of users, causing major system failures and attracting the attention of hackers. While some centralized exchanges are more secure than others, there's still been a number of security failures, like last year's Bitfinex hack, which resulted in thousands of users losing their savings (until it was later repaid).

Decentralized trading platforms offer an alternative, and perhaps even more valuable service, by promising greater security and transparency. They do not rely on third-party services to hold customer funds. Instead, peer-to-peer transactions are possible through an automated process.

The benefit of using a decentralized exchange is that there is no need to put any trust in the exchange platform itself, as the funds are held by the user in a personal wallet, rather than with a third party. Decentralized exchanges can also provide more privacy, while reducing the risk of server downtime, if only for those who are more tech-savvy.

Unfortunately, decentralized trading platforms still lack the commodity, easy of use, and overall "user support" to attract a mainstream user base. Therefore, the liquidity and market depth of these exchanges is still quite low.

Addressing the liquidity challenge 

Improving the liquidity in decentralizing trading platforms is one way to help encourage mainstream adoption. Of course, many factors contribute to the liquidity of an asset. But, if the ways in which consumers make monetary transactions using cryptocurrencies could be simplified, then it's not difficult to imagine that the demand for such assets would increase.

There's little doubt that trading cryptocurrencies will continue to take place on different kinds of exchanges for the foreseeable future without a single, more stable asset emerging to keep their value in check. This means that overcoming market fragmentation and liquidity problems will require a unique solution.

One approach to solving the challenges that exist in decentralized exchanges is to reduce the cost of the switch for cryptocurrency traders. If an on-chain platform can tap into multiple reserves, and lower the barriers of switching from one exchange to another by working with various wallet providers, then users can log into their wallets and execute a token conversion without ever leaving their wallets.

This allows receipts to access payments from any token that a decentralized platform supports.

Token-to-token convertibility is not the only approach to solving the liquidity challenge. There are many other unique ideas on how to help users execute cross-network transactions seamlessly and at reasonable rates – and these solutions are opening up entirely new ways for the greater public to participate in the cryptocurrency ecosystem.

Furthermore, liquidity is not the only factor in the adoption of the technology, but it stands to be a critical component in how the market matures. Promoting liquidity in the blockchain ecosystem, and specifically in decentralized exchanges, will be key to improving the general public's perception of cryptocurrencies as a valuable way to trade currencies safely and securely.

Disclosure: CoinDesk is a subsidiary of Digital Currency Group, which has an ownership stake in Coinbase.

Liquid paint image via Shutterstock


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