What You Need to Know About Liquidity Pools and On-chain Borrowing

20 Apr 2024

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In traditional finance (TradFi), lending and borrowing activities are facilitated by third-party financial institutions that play a crucial role in enforcing interest payments by borrowers and assessing the creditworthiness of parties involved. However, in the realm of decentralized finance (DeFi), trust in third-party intermediaries is replaced by trust in blockchain technology and smart contracts, resulting in novel mechanisms for on-chain lending processes.
A lending pool is an essential component of DeFi protocols, functioning as a smart contract that allows users to deposit assets, typically ERC20 tokens, with the intent of lending these assets to other users. Borrowers, on the other hand, can interact with the lending pool by depositing collateral assets, enabling them to secure instant loans.
Compared to traditional finance, DeFi lending pools offer significant advantages, such as:

  1. DeFi lending is not restricted by the 1:1 availability of funds for loans. Instead, a lending pool aggregates deposits from multiple users, creating a substantial inventory of tokens to accommodate loans on-demand.
  2. DeFi eliminates the need for rigid repayment schedules. Loans are issued against collateral, and borrowers have the flexibility to repay their loans whenever they choose.

A natural question arises: why would someone borrow assets in a DeFi lending protocol if they have to provide equally valued (or even overvalued) assets as collateral? The answer lies in the unique trading methodology enabled by DeFi lending protocols: leverage.

Suppose you have a bullish outlook on Wrapped Bitcoin (WBTC) and are confident its value will surge. You could deposit WBTC (e.g., $1,000 worth) into a lending protocol, borrow a stablecoin such as USD Coin (USDC), and use the borrowed funds to purchase more WBTC (e.g., $500 worth). In this case, your exposure to WBTC would increase to $1,500 from an initial $1,000 investment. Furthermore, you could deposit the additional WBTC as collateral to borrow even more USDC, a process known as over-leveraging, until the protocol's borrowing power limits are reached.

Conversely, if you have a bearish outlook on WBTC, you could deposit USDC as collateral, borrow WBTC, and exchange it for more stablecoins. If WBTC's price drops as predicted, you can repurchase the borrowed amount at a lower cost, repay the loan, and keep the excess USDC, effectively opening and closing a short position on WBTC.

To incentivize users to maintain their deposits in lending pools, interest is accrued over time as a percentage of a user's deposit, calculated by the protocol. As users' assets remain in the lending pool, their interest accruals increase. The protocol must account for each user's share of the pool without actively updating the shares of other users, as doing so on-chain would be inefficient and costly for depositors.

To address this issue, DeFi protocols employ the issuance of interest by minting and burning ERC20 tokens, referred to as "Pool Tokens," which represent a lender's proportion of deposited assets in the lending pool. This "pool token" design automatically adjusts the share dilution of other "shareholders" to reflect the minting and burning of "shares" in proportion to the deposit or withdrawal of their underlying assets.

Liquidity Bootstrapping Pools

Overcoming liquidity constraints during an Initial DEX Offering (IDO) can be a formidable challenge, posing the question of the optimum price point for token launching. Liquidity Bootstrapping Pools (LBPs) present an elegant solution, negating the need for private financing rounds and reducing the volatility associated with smaller pools.
Reframing the Launch Strategy

Instead of the conventional practices fraught with the risk of mispriced launches, entrepreneurs can leverage LBPs to source initial liquidity and permit the market to determine the initial token price. This approach also mitigates risks associated with front-running and unwanted token dilution.

One popular mechanism to facilitate this innovative strategy is Copper Launch. It allows for the addition of initial liquidity at an elevated token price, gradually reducing as more participants contribute liquidity. Eventually, the price reaches an equilibrium, signalling the market's consensus on its worth. At this stage, the market price of the token is effectively approximated.

Once the market price is established, the pool is closed, permitting the reclaiming of funds and the distribution of tokens. Consequently, these funds can be employed to seed the pool, creating a platform for the trading community.

The proposed strategy's merits include discovering a competitive market price for the token launch and providing early supporters the opportunity to invest at an advantageous price. However, a word of caution is in order. This strategy will invariably result in the initial distribution of some tokens, necessitating a token redemption mechanism to counteract the risk of front-running liquidity.

The implementation of LBPs can result in a potentially sizable number of unvested tokens in circulation. To ensure that early buyers don't immediately liquidate their tokens, the parameters of the launch pool must be set judiciously. While this introduces an additional layer of complexity to the strategy, it provides a clever solution for the persistent challenge of determining the appropriate price point while raising funds.

Undeniably, the use of LBPs in the crypto landscape enhances the fundraising mechanism's efficiency and effectiveness, thereby promoting value creation in the world of decentralized finance (DeFi).

Despite the inherent challenges, liquidity bootstrapping pools are a pioneering method for token pricing and fund-raising, as they address the needs of cryptocurrency investors and users with a high degree of precision and flexibility. The significance of this innovation lies not merely in its novelty but in its potential to reshape liquidity management in the rapidly evolving world of cryptocurrency.

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