Sunday, June 20, 2021

Projects weigh security risks, benefits of liquidity pool token collateral


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

LP tokens are distributed to liquidity providers 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 can be 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 may “maintain 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 further methods […] that is the place it will get attention-grabbing,” he stated in an interview with Cointelegraph last week

BadgerDAO is planning to launch a stablecoin — present group hypothesis is that will probably be named CLAWS — that liquidity suppliers will be capable of declare in opposition to their LP collateral.

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

“The DeFi TVL may develop as a lot as individuals are keen 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 stated.

Additional dangers

Nevertheless, in accordance with Tarun Chitra, founder and CEO of DeFi danger 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 once you wish to make extra advanced derivatives, however you need to be far more cautious.”

Chitra defined a worst-case state of affairs by which 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 costlier” in a seamless cycle.

Spadafora and Gustave additionally each warned of further 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 novel value discovery mechanism that values the underlying property within the liquidity pool in Ether.

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

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

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

Extra liquidity, extra safety

Regardless of the extra layers of good contract danger and accompanying safety issues, Spadafora thinks they will in the end be managed with correct due diligence and group religion. 

“Sure it does improve danger however once more it comes all the way down to the platform. Longer tenor, safety posture and popularity matter probably the most,” he stated.

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 might be worrying.

“Loads 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.”