Solving Liquidity Fragmentation in DeFi: Hyper-Bridges and the Future of Rollups

This year’s edition of the Blockchain Kaigi Conference, a global gathering of blockchain researchers, took place at the University of Zurich under the auspices of the Embassy of Japan in Switzerland. I’m proud to say that two of the master’s projects I advise were selected for presentation. One of these projects, which forms the basis of this article, investigates a key challenge in decentralized finance (DeFi)—liquidity fragmentation—and proposes potential methods to mitigate it.

Liquidity fragmentation is a significant issue within decentralized finance. In simpler terms, liquidity, or capital, is often scattered across various blockchain networks. Ethereum is currently the center of DeFi activity, accounting for 60% of the capital and 70% of trading volumes (source: DeFiLlama). However, as Ethereum’s DeFi transitions to Layer-2 blockchains due to high gas fees, liquidity is becoming increasingly dispersed.

Layer-2 solutions, or rollups, are non-custodial Layer-2 blockchains built on top of Ethereum. They act like separate blockchains, producing blocks at a faster rate (1 second vs. 12 seconds on Ethereum), supporting higher transaction throughput, and offering lower gas fees (less than $0.01 compared to over $10 on Ethereum). Most importantly, most of the rollups are compatible with the Ethereum Virtual Machine (EVM), making it easier to execute DeFi smart contracts originally developed for Ethereum.

However, despite their advantages, large volume trades often remain cheaper on Ethereum due to the capital fragmentation across rollups. This brings us

to the core issue: how can this fragmentation be mitigated to enable smoother trading and liquidity flow across different platforms?

Automated Market Makers

At the heart of decentralized exchanges (DEXs) are Automated Market Makers (AMMs). Unlike traditional order-book-based exchanges, where market makers determine the price, AMMs rely on mathematical formulas and token reserves to establish pricing. The most basic type of AMM is the Constant Product Market Maker (CPMM), first introduced by Uniswap.

In CPMMs, the product of the reserves of two tokens (e.g., ETH and DAI) remains constant. The larger the liquidity pool, the flatter the pricing curve, which leads to lower slippage or price impact.

Price impact refers to the difference between the displayed spot price and the executed price, which is directly influenced by the size of the trade relative to the liquidity available. More fragmented liquidity results in higher price impact.

The Solution: Hyper-Bridges between Rollups

To tackle liquidity fragmentation between rollups, a solution known as hyper-bridges is being proposed. Traditional blockchain bridges allow tokens to be transferred between chains. However, hyper-bridges go beyond mere token transfer. They enable seamless communication and resource sharing between rollups, making it possible to access liquidity from one rollup while trading on another.

System Architecture and Testing

Our team is currently testing a hyper-bridge setup between two ZK rollups, Rollup A and Rollup B. Rollup A hosts a fork of Uniswap and a liquidity pool for swapping WETH and USDC. The user, Bob, only has a wallet on Rollup B, yet wants to execute a seamless exchange of USDC for WETH.

We are measuring several key metrics, including:

• Transactions per Second (TPS): The number of transactions processed every second.
• Delay: The time between initiating a transaction and its execution.
• Finality: The time it takes for a transaction to become irreversible, both on Layer-2 (soft finality) and on Ethereum (hard finality).

Hyper-bridges work well between rollups because both rollups rely on Ethereum as their base Layer-1. This shared infrastructure allows trustless communication and capital sharing, which is harder to achieve between entirely separate blockchains.

Current Rollup Landscape

Today, many rollups exist on Ethereum, such as Arbitrum, Optimism, zkSync, and Polygon’s zkEVM. Several companies also offer frameworks for setting up custom or permissioned rollups, such as Arbitrum Orbit, Optimism Superchains, zkSync's Elastic Chains, and Polygon SDK.

In the future, once rollups share more infrastructure, such as sequencers, seamless communication and resource sharing between any public or permissioned rollups will be possible, further improving DeFi efficiency.

Conclusions

The introduction of hyper-bridges between rollups could significantly reduce liquidity fragmentation. This will not only enhance DeFi trading efficiency but will also strengthen the network effects of the Ethereum ecosystem. With more integrated liquidity pools, users will benefit from lower price impact, faster transaction times, and reduced costs, pushing DeFi further into mainstream adoption.

As decentralized finance continues to evolve, addressing liquidity fragmentation and improving interoperability between blockchains will be crucial for the industry's long-term success.

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