About the author
Mark Lurie is the CEO of Shipyard Software, the developer of decentralized exchange Clipper. Shipyard is backed by Polychain, 0x Labs, 1inch Network, and other members of the DeFi community. Mark is a former investor at FJ Labs and Bessemer Venture Partners. He thanks Dr. Abe Othman, PhD and author of the 2012 paper “Automated Market-Making: Theory and Practice” for comments and feedback.
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The crypto world loves to talk TVL. Short for “total value locked,” the term became ubiquitous during the DeFi boom of the last two years, and represents the total financial value locked up in smart contracts.
The reason TVL is on everyone’s lips is because it shows just how fast DeFi has grown. In early 2020, total TVL for Ethereum DeFi stood at barely $1 billion—while today the estimate is north of $80 billion, according to DeFi Pulse. This means there’s a staggering amount of liquidity in DeFi pools where investors and others go to earn yield. This sounds like a good thing for crypto and DeFi—and, by and large, it has been.
But the TVL bonanza hasn’t been so great for everyone.
It turns out that the largest liquidity pools, those with high TVL, pose a drawback for a key group of people: small investors. The reason has to do with how those investors pay to interact with liquidity pools.
First, let’s step back to recall how exactly DeFi transactions works. Decentralized exchanges (DEXs) enable users to swap crypto assets without an intermediary. While centralized exchanges like Coinbase and Binance use order books to match buyers with sellers, DEXs maintain standing "liquidity pools" of crypto tokens locked in a smart contract that facilitates trades with both buyers and sellers. Traders pay a fee for every trade, which returns a yield to the liquidity providers. Conventional wisdom is that the more liquidity, the better for traders, but that’s not always the case.
The first factor to consider is slippage, or the difference between the price at which a buyer places a market order—and the price that they actually pay. In centralized exchanges, there are two reasons for slippage: market volatility—prices moving around—and insufficient order depth. In the latter case, there is just not enough volume to fill the entire order at the requested price, so part of it gets filled at a higher price. In DEXs, the concept of slippage is similar, but is simply a function of TVL.
The other price factor to consider after slippage is fees. Capital always expects a return, so liquidity providers (LPs) who provide large amounts of TVL need to be paid yield. The more liquidity they provide, the more they need to be paid—and their fees are included in the user’s price. The size of each liquidity pool within a DEX has a direct impact on the exchange’s fees. Generally, smaller pools incur lower fees but lead to more slippage. Conversely, larger pools require higher fees but result in less slippage.
Crucially, the relationship is non-linear. For example, a $10,000 trade in a $10 million pool may have 10 basis points (bps) of slippage, plus fees to compensate LPs. The same $10,000 trade in a $1 billion pool has essentially zero slippage. But if trade volume is not significantly higher than in the $10 million pool, transaction fees would need to be much higher to generate a similar yield for LPs in a pool with 1,000 times the capital.
As a result, larger pools end up benefiting larger trades and negatively impacting smaller trades. Thus, more liquidity tends to hurt retail traders, who constitute the largest DeFi user base and generally place trades of less than $10,000.
Why, then, do most DeFi projects seek to attract as much liquidity as possible?
Most likely this is marketing: big numbers draw more eyeballs. That is not totally wrong-headed, as more liquidity does have the potential to attract more trade volume, which in turn could off-set the need to increase fees to meet the required yield. But this tends to hold true only up to a point. This is why our DEX Clipper, launched in July, has a liquidity pool capped at $20 million to be friendlier to retail traders.
Of course, not every DEX should cater to retail traders, and high liquidity is not inherently a bad thing. But the DeFi community’s growing obsession with attaining the highest possible liquidity is adversely affecting the vast majority of its users. The resulting dynamic echoes one of the most problematic aspects of traditional finance, in which, for example, customers with relatively small checking accounts pay the fees that enable banks to offer free services and cut-rate mortgages to wealthy clients.
Retail users should not be subsidizing whales.
DeFi’s obsession with the greatest possible TVL has the potential to recreate the same financial system that drove so many to crypto in the first place. DeFi protocols and exchanges can and should be more deliberately designed, even custom-built for specific user profiles. The innovative and open-minded DeFi community is more than capable of creating thoughtful solutions for everyone and fully entering the mainstream.
In order to build a better financial system, we need to stop focusing on higher liquidity, and start focusing on what really matters: users. The large increase in TVL over the past year shows that the model works, but the next frontier ought to be capital efficiency.