A number of decentralized finance (DeFi) tasks are shifting ahead with plans to permit liquidity supplier tokens as collateral for stablecoin and l
A number of decentralized finance (DeFi) tasks are shifting ahead with plans to permit liquidity supplier tokens as collateral for stablecoin and lending companies — although specialists 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 can be paid out upon withdrawal.
Whereas they’re typically 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 keeping 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 towards it so you may go and take extra methods […] that is the place it will get fascinating,” he stated in an interview with Cointelegraph final week.
BadgerDAO is planning to launch a stablecoin — present neighborhood hypothesis is that will probably be named CLAWS — that liquidity suppliers will be capable to declare towards 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 keen to lend out to LP tokens collateral customers, which 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 keeping 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 belongings (e.g. Maker permitting leverage on ETH/DAI LP shares), because the leverage ratio is transparently identified the lender. It does additionally make sense whenever you need to make extra complicated derivatives, however you need to be far more cautious.”
Chitra defined a worst-case situation 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, reducing liquidity in some pair, making direct liquidations dearer” in a seamless 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 belongings within the liquidity pool in Ether.
“Not all LP tokens are appropriate (as collateral), the identical means not all tokens are appropriate. You simply want to use twice as a lot diligence as there’s primarily two tokens to evaluation within the course of,” stated Gustave.
Gustave added that an Aave neighborhood member, zer0dot, has accrued 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 possible transfer to implementation shortly.
Extra liquidity, extra safety
Regardless of the extra layers of good contract danger and accompanying safety considerations, Spadafora thinks they’ll in the end be managed with correct due diligence and neighborhood religion.
“Sure it does improve danger however once more it comes all the way down to the platform. Longer tenor, safety posture and fame 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 tasks utilizing LP tokens as collateral may be worrying.
“Lots 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.”