- Current Liquidity Provision Strategies run too many risks, including impermanent loss
- For real world adoption, however, providing liquidity needs to be less volatile
- What is the end goal for DeFi, and could these protocols solve the current problems we have?
Liquidity Runs the World, in both Web 2.0 and 3.0 realities. Particularly in Web 3.0, losing money is always bad for crypto. One of the main goals of builders is to provide a unique, decentralized and most importantly “safe” environment that holds its own against promising traditional Web 2.0 investment structures.
Despite this, the DeFi industry continues to flourish for many enthusiasts willing to take the risk of impermanent loss – one of the biggest issues in liquidity provisioning. I believe that single-sided liquidity provisioning could possibly solve this problem, creating structurally safer investment products, which would be a key catalyst for mass-adoption.
DeFi’s Problem With Liquidity
Liquidity provisioning just refers to a way to farm an APR in crypto while holding a basket of tokens.
This plays off the concept of automated market makers (AMMs), which allow a decentralized experience and the bootstrapping of liquidity, effectively allowing anyone to create pools. In general, liquidity providers usually provide a 50:50 ratio in each asset, a very popular way to earn money during the bull market.
However, the main issue is impermanent loss. This is especially important during heightened market activity, since you may end up with 1 of the 2 assets that are worth less over time, and hence this loss is “realised” when traders withdraw their assets.
Theoretically, this loss is paper-loss, except those that are covered by the yield generated for providing liquidity to the pool. Of course, there are other risks such as “degen” APRs, design flaws, rugs, draining liquidity and many more issues.
The solution is simple. We need something structural, where liquidity providers get guaranteed preservation of their principal investment, through a mechanism that can prevent impermanent loss.
This is easier said than done and so far, the development of single-sided liquidity is difficult to extrapolate. However, there have been some innovative protocols exploring and innovating with this mechanism.
Providing Liquidity: is it Actually Profitable?
To quickly analyze profitability, I would advise sticking with the popular pairs and the big pools with high liquidity.
Trade Volume is an important metric to look at, and the larger the volume, the more swaps are done, leading to better revenue for liquidity providers.
Rewards/Governance Token Price refers to the normal appreciation of assets. For example, if you are farming in an ETH/USDC pool and ETH appreciates in price, your rewards will in turn increase.
Lastly, Total Liquidity is an important metric as the more TVL there is, the less rewards are given since there are more farmers.
Provisional Methods for Single-Sided Liquidity
The most obvious method would be to introduce liquidity pools only for 1:1 assets. This would mean these assets always have the same value with slight fluctuations, and hence there would be a reasonable slippage.
For example, USDC/USDT, ETH/wETH pairings.
Of course, the major downside would mean the lack of liquidity pairs and providing for tokens that only have a 1:1 ratio. That also forces liquidity providers to still be vulnerable to de-pegs, which could happen for nearly any asset. Protocols that employ this include Stargate and Platypus Finance.
Customized Impermanent Loss Pairings
A very interesting concept, impermanent-loss pairing is just a consensus that some people are willing to take in price volatility in order to provide liquidity for long-term purposes.
This includes DAO liquidity management solutions such as Rift Finance or other solutions like FlowDesk.
The key point is that DAOs are willing to provide liquidity from one side (their native token) and are willing to absorb the IL that occurs to that pool. This is much less costly for the DAO that is looking to provide liquidity in its own token. If it were done another way, those looking to trade their DAO token would have to pay for a market maker or sell their token to ETH, which would imbalance the liquidity and decrease token price.
DAOs also absorb and hence protect a user’s principal investment, unless the token’s price drops by 75%, which is still possible in crypto.
This is an interesting mechanism that still needs some fine-tuning, and can be used for financial instruments.
Dynamic Liquidity and Ceasing of Unprofitability
The initial concept of DeFi farming came from AMMs, which allowed effective and easy bootstrapping of liquidity, allowing natural price discovery.
Given this concept, AMMs could act against arbitrageurs by only allowing favorable liquidity provision trades. This would be executed using dynamic concentration of liquidity and using an oracle to create a backstop.
Concentrated liquidity is a concept familiar in Uniswap v3, a next-generation automatic market maker. In essence, they increase capital efficiency of decentralized exchanges and provide excellent yield.
Maverick protocol is one of the key contributors to dynamic concentrated liquidity, which has led to GooseFX coming with an interesting model, where liquidity providers will benefit from dynamic concentrated liquidity, reducing the amount of arbitrage that is occurring.
Furthermore, an oracle backstop can be done which would charge traders of the AMM the worst price from the market price to prevent a situation that takes advantage of liquidity situations.
However, doing so does has its limitations as it would compromise decentralization and allow the possibilities of MEV, particularly front-running.
Single-sided liquidity is gaining traction in DeFi, but has faced major setbacks given the bear market. Maturity around this concept still remains vague, but unlocking a solution to provide effective single-sided liquidity is key for mass adoption.
Until then, DeFi will still remain an industry that caters to degen farming and quick profits with unsustainable yields.
The most important thing is that innovative solutions being built now mean there is progress and room for progression. For example, Bancor is exploring single-sided exposure to protect IL through an elastic BNT supply.
Its not the best solution since it has to introduce more tokens, effectively diluting the supply and price, but trying to do something that makes a huge difference.
I foresee that with improvements coming up, we may eventually be able to find an idealistic and effective solution that will actually provide stable and sustainable yields.