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The decentralized liquidity pool is one of DeFi’s key innovations. By aggregating liquidity, it can greatly improve asset efficiency and reduce costs.
Original title: “Decentralized Liquidity Pool”
Written by: Ryan Tian, Co-founder and CFO of FinNexus
DeFi has brought revolutionary changes to financial operations. One of the subversive methods is to use liquidity pools to power financial markets. Whether it is a liquidity pool or a cash pool, it is not a DeFi initiative, but in traditional finance, such pools usually mean secret and opaque fund operations. In the blockchain, all transactions are coded by smart contracts, open to the public, without third-party custody, and the fund pool is as transparent as possible. This method of aggregated liquidity is economical and efficient in a decentralized financial ecosystem.
DeFi projects have a variety of well-designed liquidity pool models that are suitable for different application scenarios. At the same time, more and more liquidity pools are still emerging. Among them, loan pools and DEX liquidity pools are the most common. With the development of DeFi, The most recent one is the margin liquidity pool model of decentralized options.
The following table summarizes the main information presented in this article.
Loan pool model
The loan pool is the first type of decentralized liquidity pool generated in DeFi, which aims to promote the liquidity of the decentralized lending market. Different from the peer-to-peer lending model in which the borrower obtains loans directly from the lender, the lender pool directly acts as the unified counterparty of the lending transaction, and the interest is automatically set by the encoding algorithm. At present, the most famous DeFi loan pool projects in DeFi are Compound and Aave.
Compound is an open source code currency market protocol that allows users to mortgage assets to borrow. Users deposit their own assets in the liquidity pool (the “market”) for other users to borrow, and the interest paid by the lender to the fund pool is shared by all asset providers.
When users provide assets, they will receive cToken from Compound in exchange. With the accumulation of interest on the assets provided, users can exchange their cToken at a certain exchange rate. The exchange rate is determined by the interest of the underlying asset and continues to increase over time.
In the Compound loan model, there is no distribution process for interest. On the contrary, just by holding cTokens, users can automatically earn interest through changes in exchange rates.
Aave is a decentralized non-custodial money market protocol in which users can act as depositors or borrowers. Depositors provide liquidity to the market to earn passive income, and borrowers can borrow in the form of over-collateralization or under-collateralization (flash loans).
By depositing assets in the Aave fund reserve pool, users can earn interest. If users have enough collateral in the pool, they can also borrow some assets from the pool.
All deposits in the Aave agreement have a corresponding “aToken”, which is an Aave interest-bearing pass that is 1:1 linked to the value of the underlying asset.
Financial return of fund pool
The operation of the loan pool is relatively simple. The lender concentrates the funds into the liquidity pool for the borrower to borrow from it, and the interest paid by the borrower is shared by all fund pool contributors. CToken from Compound or aTokens from Aave is equivalent to the asset share of the fund pool. Although the smart contracts of various platforms may use different interest rate mechanisms, the basic principles are similar, that is, the more demand for funds in the market, the higher the interest rate.
In addition, for example, Compound also provides mining rewards for platform governance tokens, which are shared by both borrowers and lenders of liquid funds to encourage user participation.
Since lending activities are always carried out under the condition of fully collateralized in full, the loan pool is also called the lossless pool. Of course, this losslessness is for the lending standard currency. (Here we assume that the code is always valid, regardless of vulnerability)
In summary, the loan pool aggregates liquidity with lower risk characteristics and may have lower returns compared with other pools. Based on the Lego building blocks of DeFi, many projects with revenue tracking strategies have appeared on the market. These projects use the loan agreement as the basic framework of the project structure and build their own benefit tracking structure on top of this.
AMM liquidity pool
AMM mechanism and AMM fund pool
AMM stands for automatic market maker, which is a decentralized trading mechanism that relies on mathematical formulas to price assets. Different from the traditional financial mechanism that uses order book quotation matching to provide transaction liquidity, the AMM pool mechanism uses the pricing algorithm in the smart contract to automatically price assets and creates a liquidity pool for each transaction token. Projects like Balancer even Allows the creation of a fund pool that supports multiple types of token transactions.
The AMM pool provides liquidity for asset transactions in an automated manner. In other words, traders do not need to find other counterparties to sell or buy digital assets. According to the user’s share in the liquidity pool, transaction fees are automatically distributed to all liquidity providers.
At present, many AMM projects have emerged in the DeFi market, such as Uniswap, Sushiswap, Curve, Balancer, Bancor, Kyber, DODO, etc. Compared with centralized exchanges (CEX), we generally refer to such projects as decentralized exchanges (DEX) driven by AMM mechanism.
AMM pool working mechanism
The AMM pool provides liquidity for token transactions, and the structure of the number of tokens in the pool will change after each transaction. Each transaction in the AMM pool is charged a transaction fee and distributed to fund participants.
Different mechanisms are used between different AMM platforms. For example, the XYK model of Uniswap and Sushiswap is one of the most famous AMM models. Correspondingly, the automatic market-making mechanism of other projects is different from the XYK model. Curve is specially designed for stablecoin and homogenous currency transactions. It has low slippage algorithm characteristics; Balancer allows multiple tokens to be used in a pool, while allowing users to customize the composition ratio and transaction fees of the tokens. The AMM pool of Bancor v2.1 provides users with a single currency risk exposure option and resists the risk of impermanence; Kyber network uses an open reserve structure to establish liquidity; DODO uses an active market maker algorithm that allows The liquidity provider only deposits one type of token in the pool.
Financial return of fund pool
Due to the differences in algorithms between different platforms, the performance of each platform’s financial returns may vary greatly. Here, in the analysis of this article, we will mainly examine the financial returns of XYK’s automated market-making mechanism.
The main source of income in the fund pool is transaction fees and mining rewards. For example, Uniswap charges a 0.3% transaction fee, which is proportionally distributed to the liquidity provider (LP) of all fund pools during the transaction.
However, it is well known that there is a hidden danger of impermanence loss (IL) in the AMM pool.
IL refers to the losses suffered by liquidity providers in the AMM liquidity pool. When a liquidity provider provides liquidity to the pool, if the current price of the deposited asset changes from the price when the asset is deposited, it will suffer impermanent losses. The greater the price change, the greater the loss. It is worth noting that impermanence losses are relative to users who do not enter the pool and only hold relevant assets.
Uniswap and Sushiswap adopt the XYK model, the deposit ratio of trading pairs in the pool is 1:1, and the IL risk is relatively high. In Curve, the model is mainly for transactions with stable coins and homogenous coins, with lower transaction slippage and lower IL risk. Bancor, DODO and other projects also provide different solutions to this risk.
Although Uniswap has always been the king of DEXes, the risk of impermanent loss cannot be underestimated, because IL affects the financial performance of assets in the entire fund pool.
Suppose a user holds two assets X and Y of equal value, where Y is a stable currency asset. The user intends to deposit X and Y into the AMM liquidity pool at a ratio of 1:1. The black straight line in the figure below is the total asset value of X and Y when the price of X changes when X and Y assets are held at the same time. The gray curve is the financial performance when users contribute the equivalent of X and Y to the liquidity pool without any transaction fee rewards. It can be found that it is more cost-effective and profitable for users to hold assets. If the user can get some transaction income as compensation, the gray curve will move up to the red curve, and the overall income situation will improve. However, if the price of X deviates significantly from the price when the asset is mortgaged, then the user may still be better than him/ She suffered losses compared to when she held assets that did not enter the pool.
In the figure below, we simulated the comparison of the total value of the asset portfolio of two different investment methods after joining Uniswap’s ETH/USDC pool on November 27, 2019 and maintaining it for one year. Specific simulation information can be viewed by clicking this link.
Therefore, for holders of volatile assets, there may be risks in providing liquidity in Uniswap and Sushiswap, and they may not always guarantee the ultimate profit. Especially when the price of volatile tokens collapses, the AMM algorithm may even swallow most of the value of stable assets in the pool. However, mining rewards can appropriately alleviate this risk, because bonus measures can push the curve higher to the blue curve, (assuming that in the same time in the previous example, the platform subsidizes users with a 30% return rate of X Pass). But for most projects, mining incentives are still a relatively short-term and unstable return factor.
In short, the risks of AMM pools of different models vary greatly. In the XYK model adopted by Uniswap and Sushiswap, IL risk may be high. But for the stablecoin trading pool, the IL risk is much lower. At the same time, other AMM pools are innovating algorithms to reduce IL. At present, many AMM projects are creating fund pools on DEX to improve transaction liquidity, and use high mining rewards to incentivize liquidity providers. Currently, mining compensation is the main source of income for most users who provide liquidity.
Option mortgage pool
Basic concepts about options
Options are binding contracts that allow users (as buyers) to sell or purchase underlying assets (commodities, stocks, indexes, etc.) at a predetermined price within a set time frame. As the buyer of an option contract, the user has the right (but not the obligation) to buy and sell the underlying asset.
In the construction stage of an option contract, in order to obtain the right to buy or sell a specific asset at a predetermined price, the user must pay a certain consideration to the option seller, namely the option fee.
The option buyer pays the option premium and only enjoys the right. Option sellers receive premiums in return for granting corresponding rights to option holders. In order to protect the ability of the option seller to perform, the option contract usually requires the option seller to deposit collateral to ensure the performance of the contract.
In traditional finance, in theory, option sellers bear unlimited potential risks. However, option sellers are usually participants in professional institutions and can greatly reduce the seller’s risk through more complex hedging tools. At the same time, professional traders and market makers provide order book liquidity for different options trading pairs.
However, if we move these option contracts to the chain for decentralized management in the form of smart contracts, there may be some problems. For example, the lack of professional decentralized hedging tools will make it difficult for sellers to participate in transactions to diversify risks, and the liquidity of the order book on the chain is often expensive and inefficient.
Decentralized flow pool
Decentralized options projects represented by Hegic and FinNexus, which aggregate sellers’ funds in a mortgage pool and provide liquidity for option transactions, are a major innovation of DeFi.
In traditional finance, option agreements usually exist in the form of peer-to-peer bilateral contracts. However, the on-chain option contracts of Hegic and FinNexus innovatively adopt a point-to-pool model, which concentrates liquidity in the mortgage liquidity pool. These liquidity pools constitute a unified counterparty for all options with different terms, and at the same time provide full performance collateral for the options. Risks and option fees are shared fairly by all liquidity providers according to their shares. Therefore, no individual user is at high risk, and all participants can share the benefits.
For example, the operation of the USDC liquidity pool of FinNexus is as follows:
Financial return of option mortgage pool
Measuring the financial performance of the option mortgage asset pool is different from the two models introduced above, and is relatively complicated.
The options in the option mortgage pool are closely related to probability. The famous BS option pricing model is based on probability theory. From a mathematical statistics point of view, if the option price is reasonable, the option seller is usually more likely to win, but in actual application scenarios, the case situation is generally more complicated. The option mortgage pool provides liquidity for option transactions and acts as a seller of options on various terms. This pool model is equivalent to a fund selling options. In theory, the reliability and stability of the financial returns of the option mortgage pool may take months or even longer to be reflected. Nevertheless, there are still some methods to test the financial status of the fund pool.
As we all know, crypto assets like BTC and ETH have high volatility. Therefore, to understand through common sense, options may be more friendly to holders, that is, option holders are more likely to benefit, because option holders only have rights and no obligations to bear, and the loss of option holders is only Limited to the option cost itself.
Is this really the case?
Before starting mathematical analysis, we must first realize that volatility is an important parameter for option pricing. The options for volatile assets are more expensive. This volatility parameter can be measured by the implied volatility in the BS option pricing model. In the following analysis, we use historical average volatility to price options.
First, we calculate the average volatility of BTC options during the two and a half years from March 29, 2017 to November 26, 2019, including 1 day, 2 days, 3 days, 7 days, 15 days and 30 days. Volatility.
Secondly, using the above volatility, calculate the price of ATM options on each expiry date in the most recent year from November 27, 2019 to November 27, 2020.
Third, assuming that the capital pool sells the same number of put options and call options, we can get the seller’s profit and loss on each expiry date in the same period.
Finally, referring to the trading volume on Deribit, we can assign different weights to options with different expiration dates to obtain the average expected APR and maximum drawdown of the option mortgage pool.
For more information, please click on this link computing inspection .
The red curve in the above figure is the estimated fluctuation of the net value of the option mortgage pool measured in USD, and the blue curve is the price of BTC.
In the long run, although there will be a retracement, the liquidity pool as the seller of collective options has a greater probability of profitability. In the last 12 months, assuming that the collateral in the pool is fully utilized, the net value of the fund pool has increased by more than 60%, which means a 60% APR return. If the average utilization rate of the collateral is 50%, the APR can be 30%, and the corresponding drawdown will be smaller.
As can be seen from the above figure, if the unilateral BTC price fluctuates for a long time, the pool will lose money, especially in the period from March to May and October to November in 2020.
Using the same calculation method, we can simulate the financial return of the Ethereum option pool in the last 12 months, as shown below. Please click this link for specific simulation information.
The option mortgage pool is different from the loan pool and the AMM liquidity pool. The option collateral pool provides option liquidity and collateral to obtain option costs as a return and bear the risk of option redemption as a price. If the market price of the underlying asset changes unilaterally, a loss retracement may occur. But in the long run, the benefits of price changes outweigh the disadvantages of liquidity providers, and liquidity providers can benefit from it.
Other funds pool
In addition to the three types of pool models described above, the DeFi market also has other types of fund pools, such as YFI, YFII, Harvest’s machine gun pool, and lock-up pools for voting, mining or revenue enhancement, including CRV , Hegic et al. The income of these fund pools can be measured in different standard currencies, or different strategies can be used to create a differentiated risk-return portfolio. For example, the machine gun pool currently mostly adopts the non-destructive mining investment strategy of the functional currency, which is realized by collecting mining and selling mining profits. With the continuous combination of decentralized financial tools, the machine gun pool is also developing a fund pool with more complex investment strategies. There are also platforms on some platforms that can accelerate other mining income through platform currency lock-up mining, and platform currency lock-up can also collect transaction fees in return, and has the role of voting rights in platform decisions.
Decentralized liquidity pool is one of the greatest innovations of decentralized finance. Through the decentralized liquidity pool, all liquidity can be efficiently pooled, thereby maximizing asset efficiency and reducing costs. At the same time, blockchain technology can ensure the open source and openness of the fund pool without being censored. At the same time, endless DeFi projects and models continue to provide users with more diversified liquidity aggregation solutions, and provide users with different risk preferences with more choices. Although DeFi products are becoming more abundant, users should carefully study the similarities and differences of each platform, understand the characteristics of each fund pool, and then invest to avoid unnecessary losses.