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One of the main goals of investing is to make sure your money is working for you at all times, whether that’s through a savings account you barely glance at or through high-activity stock trading.

In the past, a savings account with a 10 percent return was a reliable and safe option for many people. However, today’s financial landscape paints a different picture.

The pursuit of meaningful returns has shifted investors’ focus to solutions based on blockchain and DeFi (decentralized finance).

However, with a DEX (decentralized exchange), the search for optimal capital efficiency goes beyond blockchain networks.

And without a way to meaningfully solve challenges like fee spikes, liquidity shortages, and market inefficiencies, DEXs are doomed to fail.

In this scenario, the crucial question is – wWhat challenges related to capital inefficiency are unique to DEXs and how can developers ensure that resources are allocated appropriately to close these gaps?

DEX liquidity issues

First, we need to look at LPs (liquidity providers), who face a differentiated reality within DEXs. LPs often engage in decentralized platforms with expectations that may not be met.

Of course, they aim to earn more than their initial stake through trading fees and possible incentives.

However, an LP’s profitability is typically affected by a wide range of factors, most of which are beyond its control.

For example, market conditions, fluctuating prices, and varying demand can affect trading volume and directly impact the fees LPs earn.

High trading volumes typically result in higher returns, but market declines can result in lower activity and lower fees.

More specifically, LPs face significant risk because the value of their assets can fluctuate due to price differences.

During times of high volatility, LPs may incur losses to traders because the fees generated cannot compensate for the temporary loss.

Therefore, DEXs must focus on positioning LPs for long-term success and increasing their presence over time.

Another criticism of decentralized platforms is the impact on prices. However, in comparison, price control on CEXs (centralized exchanges) is relatively low.

For example, the AMM (Automated Market Maker) model of the second version of Uniswap was capital inefficient, resulting in LPs losing out to traders.

Despite the growing popularity of DEXs, the majority of trading activity still takes place on centralized exchanges, with significant liquidity flow between the two.

On CEXs, traders often overpay, which benefits arbitrage traders who transfer liquidity between platforms.

This dynamic underscores the challenges DEXs face in delivering the promised improved liquidity and lower trading costs to traders.

While DEXs offer unique opportunities for LPs to participate in DeFi, the process is not straightforward.

And if DeFi platforms are ever to realize their capital efficiency potential, their developers will need to refine certain features immediately.

How to achieve the change towards capital efficiency

Simply put, LPs need access to more flexible liquidity solutions to use capital more efficiently.

Currently, many LPs are engaged in long-term liquidity provision and diversify their assets across wide price ranges.

For example, imagine a pool for Solana and USDC where an LP distributes liquidity from zero dollars to infinity.

Part of the liquidity is reserved for a price range of zero to one dollar, and part is also reserved for the range of 100,000 to 1 million dollars.

Since Solana’s price is unlikely to fall within the two corresponding price ranges, the reserved liquidity for the given price range is never used. Therefore, the capital does not earn APY (annual percentage yield).

LPs can also benefit from concentrated liquidity to optimize asset provision, enabling them to achieve higher returns while ensuring efficient capital productivity.

If we follow the example above, this approach would allow LPs to convert Solana assets into USDC using the funds allocated to the liquidity pools.

To fill the gaps in DEX systems, LPs’ desire for flexibility in options must also be taken into account.

By offering a range of risk-return options, LPs can be better served by different risk tolerance levels, improving overall capital efficiency.

Virtual margin liquidity represents a new risk-return choice that would fall into this category.

While this may initially result in lower returns for traditional LPs, it also reduces their risk, while virtual margin providers take on the risk in exchange for higher returns.

Use of mean reversion strategies – Benefit from the return of asset prices to normal levels while volatility eases – can also improve capital efficiency.

This approach can benefit traders and LPs who have concentrated their assets and potentially increase efficiency for DEX LPs.

While centralized authorities have historically outperformed their decentralized counterparts, DEXs are evolving to address these challenges and attract a broader user base seeking to reap the benefits of decentralization.

However, significant improvements to current operations are required to improve capital efficiency.

By focusing on specific areas, DEXs can both improve the user experience and build trust among LPs, leading to higher participation and growth.

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Kilian Peter Krings is the CEO of Stabble, a Solana-based liquidity and trading layer. Kilian leads the protocol with extensive experience in the decentralized and traditional finance sectors. With a proven track record of advising over 15 crypto projects and co-creating an IDO launchpad, Kilian leverages his expertise across the blockchain ecosystem to drive Stabble’s growth and development.