Decentralization brings untold benefits to the financial industry, introducing trustless protocols with self-custody of assets, helping to foster innovation and give users more control. But like all new technologies, it must overcome some tricky hurdles if it’s to go mainstream, and few are bigger than the challenge of liquidity.
The lack of liquidity in DeFi is a significant problem because decentralized protocols are entirely reliant on it, and if they don’t have it, it can prevent them from functioning properly, resulting in uncontrollable asset price volatility, high slippage and inefficient market making.
The issue stems from the fact that decentralized exchange platforms and protocols have to create their own liquidity, which involves tapping their user base. So the available liquidity on any given DEX is restricted by how many users it has, as it’s these people who are incentivized to deposit tokens in its liquidity pools. If a DEX platform doesn’t have sufficient liquidity, users can struggle to buy and sell assets at the prices they desire, and in some case their orders may just go unfulfilled. It’s a state of affairs that cannot persist if DeFi is to be taken seriously.
Fragmentation Frustrations
A quick check on DefiLlama shows that liquidity shouldn’t really be a problem for the industry, as there is currently more than $99 billion worth of value locked in the DeFi ecosystem. However, DeFi’s problem is one of fragmentation. These days, there are dozens of different blockchains that all support DeFi applications. Each of these blockchains is an independent network. They each have their own consensus algorithms, hashing techniques and transaction processing speeds, with different block sizes and so on. This makes them incompatible with each other, meaning the transfer of crypto assets across them is very difficult.
For instance, Ethereum is the biggest DeFi blockchain but it only accounts for roughly half of the total value locked. Other popular DeFi chains, such as Avalanche, Aptos and Solana, have a much smaller share of the TVL in DeFi. So the available liquidity is fragmented across many different chains, meaning each protocol can only access a fraction of the available capital.
Because of this fragmentation, one of the biggest challenges for any innovative new protocol is to bootstrap the liquidity it needs to get off the ground. Much of their effort is focused on attracting the liquidity providers necessary to sustain the new protocol, which means less time can be spent on the actual innovation. It’s a resource-intensive challenge that creates a high barrier to entry for new protocols.
Fixing Fragmentation
Within the DeFi industry, the vast majority of decentralized protocols are focused on spot trading and perpetuals. Alternative markets, such as options, have barely made a dent in the DeFi space.
Looking to change this, Ithaca Protocol has created a non-custodial risk primitive that aims to grow on-chain options volume into the billions of dollars. Importantly, it says it will do so by solving the challenge of liquidity fragmentation. Ultimately, it hopes to scale the DeFi options market to trillions of dollars, meeting the enormous demand for structured payoffs.
Ithaca’s solution to the problem of liquidity fragmentation is a novel matching engine that essentially distills option payoffs into composable building blocks built with smart contracts. In this way, it will support atomic order matching with conditional order logic. It does this based on principles such as replication, portfolio dominance and collateral optimization.
Its solution sounds complex and indeed it most definitely is, but it’s also quite ingenious. Ithaca gets around the fragmented liquidity and the absence of risk-sharing mechanics in DeFi options with a permissionless infrastructure that enables liquidity to be aggregated across chains, supporting more efficient risk sharing across time and event horizons, and ultimately, more efficient markets. Its secret sauce is an algorithmic, auction-based market clearing framework that’s resistant against Miner Extractable Value or MEV manipulation. In addition, the framework also supports the deployment of composable options and structured product markets for almost any DeFi asset.
The Ithaca Matching Engine consists of a number of moving parts. It implements Frequent Batch Auctions at discrete intervals, effectively matching orders through auctions rather than traditional order books. It also introduces the concept of Risk Sharing Building Blocks or RSSBs, which are defined as statically replicable derivatives that are directly integrated within it to ensure orders are matched at the atomic level.
Mixed Integer Linear Programming Optimization enables the matching engine to search for clearing prices and associated sets of consistent orders that satisfy those prices in an optimal way that maximizes the executed volume and satisfies users’ best execution requirements. Finally, it also employs a “Portfolio Dominance” mechanism to ensure matching is done in a riskless way, by consolidating orders and matching them to ensure the protocol assets always exceed liabilities.
Everything is tied together by smart contracts that enforce post-trade settlement, with collateral requirements taken care of by a novel Collateral Optimization Engine. Axelar’s cross-chain gateway protocol performs the role of bridging assets across multiple blockchains, aggregating liquidity. All of this takes place under the hood, within the Ithaca app that enables professional traders to implement a range of options trading strategies, including simple payoffs and more complex, structured products.
Jumpstarting DeFi Options
Ithaca’s team has high hopes for its protocol, saying it wants to embed it at every stage of the lifecycle of risk-sharing instruments. It’s an ambitious project to be sure, because Ithaca is building what is really an entirely new kind of infrastructure that will reimagine DeFi’s derivatives markets. But if it pays off, it could well be just what DeFi needs to solve its liquidity fragmentation once and for all.
