At least $15bn or 33% of DeFi's TVL is trapped.
They say composability promotes capital efficiency.
But existing infra does not support max composability, or have we?
A 🧵 on where we are and how we can unlock them (1/21)!
This thread will be split into 5 parts:
1️⃣ Background [3-5]
2️⃣ The problem [6-9]
3️⃣ Existing and potential solutions [10-14]
4️⃣ Why it matters to you [15-16]
5️⃣ Personal thoughts [17-18]
1️⃣ Background
DEXes have always been a liquidity hotspot in DeFi, consistently ranking among the top 3 categories.
During the bull market, DEXes even held the first place.
Liquidity in DEXes is derived from LPs—users who provide liquidity to a DEX (AMM) to facilitate trading, in exchange for fees (and are given LP tokens as receipts).
Composability refers to the ability to use these receipt tokens on other platforms to create new instruments.
At the 'simplest' level, using these receipts as collateral boosts capital efficiency because the same dollar can be used multiple times.
In the scope of this thread, let's use their (long-term) collateral utility as a proxy for composability.
2️⃣ The problem
How easy is accepting LP tokens as collateral? It's hard.
The typical DeFi lending markets operates on shared-pools, oracles and liquidations to monitor the protocol's and lenders' health/exposure.
To qualify as collateral in the typical lending market, an asset must have:
1. Oracle support (to monitor real-time value)
2. Deep liquidity (to account for liquidations)
3. Proper parameterisation (to balance the protocol's exposure to assets with different risk profiles)
When LP tokens are liquidated, it's redeemed to the underlying asset, which is then sold (now to a pool with less liquidity). This would spark liquidation cascades.
Not a scalable and safe design.
Not to mention LP tokens' lack of oracle support. It can't scale.
Expanding on it, he issues of enabling LP tokens as collateral are:
Market:
- Liquidity requirements
- Cyclical liquidation
Asset:
- Pricing issue
- Counterparty risk (exposure to underlying asset)
- Incompatibility with shared model
- Farming rewards support
- V3 design
3️⃣ Existing and potential solutions
With all the above, it doesn't mean that LP tokens cannot be used as collateral at all.
For example, @fraxfinance @SiloFinance @MIM_Spell has accepted several LP tokens as collateral.
Either through isolation or parameterisation (risky).
LP tokens with deep liquidity and pricing support can easily be supported. Though this returns only a few eligible ones (typically Curve stable pools).
Here is the list of deepest LP pairs: about half of them are stable-pairs.
Auto-compounders solve the hassle of farm rewards. Props to @beefyfinance @tetu_io.
Better yet, native ERC-4626 LP tokens do wonders. @AuraFinance
V3 LPs are a tad more tricky, but can be 'solved' through the use of ALM providers, such as @GammaStrategies @ArrakisFinance .
The above solutions: deep and stable pairs, auto-compounders and ALMs can be used in tandem, to expand the asset support.
Now the bottleneck is on the LP token's liquidity due to the cyclical liquidation issue.
Note: LYFs exist, though they merely serve leverage loops.
What if there's a lending market that runs on neither oracles nor liquidations?
Used with the above solutions, the possibilities are now limitless.
Well, that's exactly what we're building over at @TimeswapLabs.
twitter.com/0xMughal/status/1672295197299085313
4️⃣ Why it matters to you
Recycled liquidity fosters faster growth (but also faster downturns).
This also means less emissions are required as the opportunity cost of LP-ing is lower, and leverage loops can be used to bootstrap liquidity.
Increased degeneracy.
As an ecosystem, this is real 🐂!
For teams and long-term holders, you can unlock capital on your long-term holdings!
5️⃣ Personal thoughts
Markets with isolated pools are necessary to silo the contagion risks of assets with very different risk profiles. Security over efficiency, right?
Semi-isolated models work too, and will definitely be on my watchlist.
Creating an infrastructure that offers collateral utility is crucial, even if not all assets require it.
The above applies not only to DEX LP tokens but also to other receipt tokens (e.g., GM of @GMX_IO V2, LLP of @Level__Finance,
etc.).
Imajin ser, imajin.
Thanks for your support frens ❤️
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