Fragmentation of Liquidity Due to Layer 2 Solutions on Ethereum

The proliferation of Layer 2 solutions on Ethereum (ETH +3.29%) is fragmenting liquidity across the network, several analysts have said.

The range of Layer 2 solutions on the Ethereum network, including Arbitrum, Polygon, and Optimism, represents diverse strategies aimed at addressing scalability issues.

“It’s been argued that the large number of Layer 2 blockchains emerging to combat scalability issues on the Ethereum network is causing a fragmentation of liquidity across the blockchain, weakening the operations and adoption of a blockchain or applications on that blockchain,” said Patrick Liou, Gemini Principal of Institutional Sales, in a statement to The Block.

A recent Gemini institutional insights report noted that a new Ethereum Layer 2 appears every 19 days, raising concerns about the fragmentation of liquidity, which refers to the availability of assets for trading.

Liou emphasized that moving liquidity between blockchains can be challenging but advancements in bridging applications are improving this process and could facilitate smoother liquidity flow between networks.

Layer 2 module design affecting liquidity

Issues with Layer 2 Module Design

A CoinShares research blog from March discussed similar concerns, stating that Ethereum Layer 2 roll-ups have “unintentionally fragmented liquidity and composability, reducing the overall application, developer, and user experience.”

According to the CoinShares report, each Ethereum Layer 2 processes transactions in a centralized manner for their own asynchronous asset ledgers and smart contracts. This modular approach contributes to a fragmented global state, negatively impacting liquidity.

CoinShares analyst Max Shannon also highlighted that Layer 2 solutions, due to their asynchronous sequencing and proprietary technology stacks, exacerbate fragmentation, presenting major challenges to liquidity, interoperability, and social coordination.

Long-Term Impact on Ethereum Market

Despite these fragmentation issues, Liou reassured that past concerns of liquidity fragmentation have had little long-term impact on Ethereum’s market development.

“For example, the 2020-21 congestion on the Ethereum network caused astronomical gas fees, ultimately encouraging the creation of Layer 2s but did not significantly affect the growth of the Ethereum market,” he mentioned.

Liou concluded that the multitude of Layer 2 solutions, each providing unique use cases and benefits, results in a surplus of blockspace, presenting developers with opportunities to innovate applications for consumers, stimulating market development moving forward.