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Initiatives weigh safety dangers, advantages of liquidity pool token collateral

01/19/2021

Liquidity pool token-backed collateral may bolster DeFi’s TVL, however can or not it’s used securely?

A number of decentralized finance (DeFi) initiatives are transferring ahead with plans to permit liquidity supplier tokens as collateral for stablecoin and lending providers — although consultants warning that the safety issues related to utilizing LP tokens on this method may be complicated. 

LP tokens are distributed to liquidity suppliers on automated market makers (AMMs) to characterize a supplier’s stake in a liquidity pool. Suppliers are incentivized with buying and selling and protocol charges which are paid out upon withdrawal.

Whereas they’re usually the final cease in a cycle of yield farming transactions, a number of DeFi platforms are actually contemplating utilizing them as collateral, together with MakerDAO, Aave, and BadgerDAO — a transfer that might “preserve the cycle going” for yield farmers, in accordance with BadgerDAO’s Chris Spadafora.

One other step within the cycle

“When teams like us are capable of say, “Oh, you may unlock this illiquid place, and borrow in opposition to it so you may go and take extra methods […] that is the place it will get fascinating,” he mentioned in an interview with Cointelegraph final week. 

BadgerDAO is planning to launch a stablecoin — present neighborhood hypothesis is that it will likely be named CLAWS — that liquidity suppliers will have the ability to declare in opposition to their LP collateral.

The potential advantages of unlocking this liquidity are important — and never only for particular person merchants. Jordan Gustave, the COO at lending platform Aave says that it may increase the ecosystem and inflate figures like DeFi’s closely-watched complete worth locked (TVL).

“The DeFi TVL may develop as a lot as individuals are prepared to lend out to LP tokens collateral customers, that means that if I’ve sufficient liquidity to make use of my ETH/WBTC as collateral, then one may go simply 3x lengthy on the LP token and use the extra liquidity to farm UNI / Sushi / [Balancer],” he mentioned.

Further dangers

Nonetheless, in accordance with Tarun Chitra, founder and CEO of DeFi threat evaluation agency Gauntlet.Community, utilizing LP tokens as collateral prompts particular issues depositors and platform designers want to bear in mind. 

“It is sensible when the lender controls one of many property (e.g. Maker permitting leverage on ETH/DAI LP shares), because the leverage ratio is transparently recognized the lender. It does additionally make sense if you wish to make extra complicated derivatives, however you must be rather more cautious.”

Chitra defined a worst-case situation wherein LP tokens may result in cascading, deflationary liquidations throughout the DeFi ecosystem. On this case, “LP token debt defaults, LP tokens are liquidated, decreasing liquidity in some pair, making direct liquidations dearer” in a unbroken cycle.

Spadafora and Gustave additionally each warned of extra dangers surrounding oracle assaults, a subject that Aave explored in-depth once they selected to permit Uniswap v1 collateral, going as far as to develop a singular worth discovery mechanism that values the underlying property within the liquidity pool in Ether.

“Not all LP tokens are appropriate (as collateral), the identical approach not all tokens are appropriate. You simply want to use twice as a lot diligence as there’s basically two tokens to evaluation within the course of,” mentioned Gustave.

Gustave added that an Aave neighborhood member, zer0dot, has collected sufficient proposition energy in governance to push ahead a Uniswap market that can assist v2 tokens as collateral on Aave.

As with MakerDAO and Badger, the Aave proposals seem like tremendously standard and can seemingly transfer to implementation shortly.

Extra liquidity, extra safety

Regardless of the extra layers of good contract threat and accompanying safety considerations, Spadafora thinks they’ll in the end be managed with correct due diligence and neighborhood religion. 

“Sure it does improve threat however once more it comes all the way down to the platform. Longer tenor, safety posture and repute matter essentially the most,” he mentioned.

In the meantime Chitra, who has researched the economics of liquidity provision extensively, urges warning and says that the frenzy of initiatives utilizing LP tokens as collateral may be worrying.

“A whole lot of protocols appear to implement it haphazardly and that is nerve-wracking. Maker is the one place that appears to be diligent about their LP share borrowing.”