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DeFi tools Research

Understanding Single Sided Liquidity Pools – Why Defi Needs This Solution?

A liquidity pool is a smart contract implementation on AMM DEXs that allows users to provide liquidity to DeFi markets in exchange for transaction fees and rewards.

DeFi is an emerging wing of finance that brings to the world innovative investment tools with a variety of applications and significant profit making opportunities over short intervals of time. The potential of DeFi has attracted the participation of investors from across and beyond the crypto community.

The myriad use cases of DeFi extend beyond financial incentives to establish a solid alternative to traditional financial solutions, with an added advantage of higher transparency, increased control and affordability. As a result, it is not surprising to witness the exponentially increasing popularity of DeFi applications.

Widely used applications like DEXs, stablecoins, lending and borrowing protocols, and more are key drivers of DeFi adoption. These protocols, eliminating the need for middlemen, rely on peers for liquidity and on-chain smart contracts for transaction execution.

Whether the desired goal is to hoard tokens in wallets or put them to use to generate passive income, liquidity is necessary for users to acquire the cryptocurrencies of their choice. A solution for this need is the liquidity pool native to the DeFi landscape.

What Is a Liquidity Pool?

A liquidity pool is a digital supply of cryptocurrency that is secured by a smart contract. As a result, liquidity is produced, allowing for quicker transactions.

Users providing liquidity, known as liquidity providers (LPs), stake tokens into liquidity pools in pairs, often in the 50:50 ratio. Although these are the most popular kind, different types of liquidity pools exist in varying ratios.

Staking tokens in pairs is a necessity due to how the liquidity pool uses AMM algorithms that bring efficient market-making capabilities on-chain. Such type of liquidity provisioning was made possible by the first-ever AMM DEX – Bancor.

Subsequently, it was made popular thanks to Uniswap which remains one of the most popular among AMM DEXs, reporting the largest trade volumes for an application of its kind in the DeFi space.

Liquidity Pool Trading

To understand how liquidity pools work an example is in order. The ETH/USDT pool, one of the more popular pools on Uniswap, requires LPs to stake an equivalent value of ETH and USDT. For example, a $1000 stake of ETH would warrant $1000 worth of USDT to be staked alongside.

The asset pairs held in the liquidity pool enable users to swap one token to another. A user intending to acquire USDT can deposit ETH to the respective contract on the AMM DEX which will be added to the underlying liquidity pool and receive an equivalent value of USDT from the same pool, minus the transaction and swap fees.

The LPs receive transaction fees for every trade or “swap” proportional to their stake in the entire pool as an incentive for staking their assets. Uniswap LP returns, for instance, are known to offer 0.3% of every swap as a transaction fee to LPs.

On top of that, LPs receive LP tokens for staking in pools which can be further deposited in liquidity farming protocols to earn additional gains. In certain cases, the LP tokens have risen greatly in value themselves leading LPs to accrue insanely high profits from yield farming protocols.

As attractive as the profit-making possibilities with liquidity pools are, there are definite risks involved which if not understood can lead to huge dents in investors’ pockets.

Liquidity Pool Risks

While liquidity pools play a central part in the functioning of DeFi ecosystems, they are flawed in certain ways that could lead to potential losses for individuals providing liquidity. One of the most evident risks associated with staked assets in a liquidity pool is price volatility.

In the current state, users are required to stake crypto assets in pairs, and drastic price fluctuations could expose them to potential loss in value of both staked assets irrespective of whether they like it or not. Such a scenario is better known as involuntary exposure.

Further, the volatility creates heightened exposure to risk with cryptocurrency investments not only while holding them but also through a phenomenon unique to liquidity pools known as impermanent loss.

This kind of loss occurs when the values of the staked assets change – up or down – due to larger market movements. Consequently, arbitrage opportunities occur due to varied token prices between the pool and the larger market leading to trades that change the ratio of the asset pairs in the pool.

The combination of the market movements and change in asset ratios lead to LPs losing out on potential gains if they held onto their assets in their wallets instead. The impermanence of the loss lies in the fact that it can be recovered if the asset prices return to their initial price at the time deposit.

The loss, however, becomes permanent if the LP withdraws their stake from the pool before it is rectified. The fees and rewards accumulated can offset the losses at times, but simply holding the tokens in a wallet can make decent profits, let alone breaking even, leaving LPs dissatisfied.

The impermanent loss phenomenon is quite common with liquidity pools, leading novice LPs to face immediate hurdles while trying to generate profits. Moreover, more seasoned DeFi users refrain from indulging in liquidity provisioning because they see impermanent loss as an issue.

Thus, developers have been working on alternatives that will not only prevent LPs from facing impermanent loss but also allow them to reap decent profits. One such alternative is known as the single sided liquidity pool, helping LPs avoid the shortcomings of regular liquidity pools.

How Do Single Sided Liquidity Pools Work?

The single sided liquidity pool allows LPs to stake a single asset in it, while the other asset in the pair is staked by the protocol and is usually the protocol native token.

Not only do these pools minimize the LPs’ risk exposure to one asset, but they also prevent them from incurring permanent losses if they choose to withdraw the staked asset when it is afflicted by impermanent loss. Therefore, LPs have less to worry about as compared to staking in regular liquidity pools.

There are few single sided liquidity pools in DeFi, on platforms like Bancor, AAVE and Compound. InstaDEX is also one of the platforms that is championing the implementation of single sided liquidity pools for Tezos-based and multichain compatible crypto assets.

The single sided liquidity provisioning allows users on platforms like InstaDEX and others to stake just one asset to the liquidity pool instead of asset-pairs like in conventional AMM DEXs.

In this set-up, the platform pitches in by contributing an equivalent value of the corresponding asset to the pool to balance the value of both supported token-pairs.

By offering single sided liquidity provisioning, InstaDEX offers the flexibility of choosing the asset they wish to stake, based on their existing crypto portfolio and risk appetite.

Anyone holding just one asset can also become an LP and earn returns without having to split their portfolio by swapping the tokens just to fulfill the liquidity provisioning requirements.

Single Sided Liquidity Pools and Impermanent Loss

By participating in single sided liquidity pools, LPs will continue to earn rewards in the form of a percentage of swap fees charged by the DEX, while leaving them free to stake the LP tokens received against their contribution to the pool on any supported liquidity farming contracts.

With the LPs exposure limited to just one asset in the liquidity pool, the scope for impermanent loss is very less to absolute zero.

Users providing single sided liquidity will be able to withdraw equivalent amount of assets from the pool at any time, and the value of the said asset will remain the same as prevailing market conditions, just like it would have been in case they had just held on to it in their own wallets.

Meanwhile, to ensure the overall health of the liquidity pool and minimize potential losses to those with exposure to both assets in the pool some platforms have impermanent loss insurance in place.

The IL insurance is backed by a treasury funded by a small percentage of transaction/exchange fees and depending on the set policies and the condition at the time of withdrawal of liquidity by the LP, the insurance will compensate for any impermanent losses they incur.

Single Sided Liquidity Pools Are Making Liquidity Provision Convenient

Liquidity pools are an important aspect of DeFi without which the activity witnessed on various protocols will dwindle. The issues prevalent with liquidity pools, however, need to be corrected so LPs face lesser risks because of protocol makeup and receive better incentives while staking to provide liquidity.

Single sided liquidity pools avoid impermanent loss and multiple token exposure, offering improvements to DeFi’s conventional liquidity provision methods.

By covering losses and simultaneously incentivizing users for liquidity provisioning, single sided liquidity pools are making aspects of DeFi much safer and predictable for users.

Moreover, this is attracting more liquidity into DeFi ecosystems allowing LPs to make greater sums. As liquidity increases, users across DeFi protocols can swap for needed tokens easily with no worries of slippage and interact with plenty more use cases and applications.

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DeFi tools Research

Impermanent Loss in DeFi- How Liquidity Providers Can Avoid It

Financial instruments exist to help individuals and institutions save, manage, and grow their assets. Yet many investors find themselves unhappy or lacking motivation to indulge in most of the traditional asset classes due to a variety of reasons, some of which includes issues with accessibility, associated costs and regulatory red tapes, large ticket sizes combined with low returns and more. All these factors have led them on a search for attractive alternatives, conveniently offered by DeFi.

Evolving from the technology underlying Bitcoin, followed by the introduction of the first ever programmable blockchain in the form of Ethereum, DeFi is the application of the very technology to create financial solutions. DeFi, short for Decentralized Finance, now provides a viable alternative to highly centralized traditional financial systems.

DEXs in DeFi

Powered by crypto assets, the applications of DeFi range from simple exchange/swap solutions to lending, insurance, and other yield generation instruments. It is open for everyone to participate, enabling them to invest and generate returns without the hurdles faced in traditional finance. In most DeFi instruments, users are always in control of their funds and play a crucial role in ensuring continued operation of these solutions.

Decentralized Exchanges – DEXs, play a pivotal role in the DeFi ecosystem. Its importance is underlined by their presence in native form on each of the many blockchain protocols out there. Apart from allowing users to exchange one crypto asset to another, they also pave the way for various other DeFi activities like staking and yield farming.

Liquidity Provisioning on DEX

For an exchange platform to operate, they need to have liquidity in the form of tokens for each crypto pair they support. Centralized exchanges maintain a huge liquidity pool composed of user deposits along with their own funds that enables uninterrupted exchanges and trades. However, in a decentralized context, there is no centralized pool. Instead, they rely on the community members providing liquidity by depositing their holdings into respective liquidity pools, in exchange for rewards.

Such a model, automated by smart contracts is known as Automated Market Maker model and the DEXs are called AMM DEXs. Few examples of AMM DEXs on different protocols include Uniswap on Ethereum, QuickSwap on Polygon, QuipuSwap and InstaDEX on Tezos and so on.

As Liquidity Providers (LPs), community members stake their crypto assets, usually in pairs, into the liquidity pools present in automated market maker (AMM) DEXs. Other users looking to exchange their assets can select the relevant token pair listed on the platform and deposit one of tokens into the smart contract to receive an equivalent value of another into their wallets to complete the swap process.

The deposited token gets added to the liquidity pool to affect the withdrawal and transfer of the other token from the same pool.

For their contribution to the ecosystem, LPs receive a portion of the transaction fees on swaps charged by the platform from its users as rewards. Sometimes, the LP tokens received by liquidity providers as a confirmation of their contribution to the pool can be deposited in certain DeFi farms to earn additional rewards.

While liquidity provisioning acts as an attractive passive crypto income generating activity, it is also associated with risks that could lead to LPs losing large sums of value, like rug pulls, flash loan attacks and impermanent loss- the latter of which can be avoided or mitigated with the right information.

The saying “the greater the risk, the greater the reward” applies even more for a segment as volatile as cryptocurrency but a smart investor usually works around the risks present to make steady profits in the long run.

What is Impermanent Loss in DeFi?

Impermanent Loss is an unrealized loss that LPs only notice upon withdrawing their asset pairs from liquidity pools. It refers to a reduction in the dollar value of these staked assets as compared to their dollar value if the LPs just held on to them. By deciding to not withdraw their assets and wait it out instead, there’s a chance that the loss could correct itself- hence named ‘impermanent’.

How Impermanent Loss Occurs, With an Example

It would obviously make more sense to explain such a technical concept with an example that will aid in understanding better.

Let us say, a liquidity provider, LP1 decides to provide liquidity to a 50:50 ETH/DAI pool on Uniswap. The person stakes 10 ETH at a price of $1000 per token and an equivalent value of 10,000 DAI to secure a 10% stake in the pool containing a total of 100 ETH and 100,000 DAI.  Following LP1’s contribution, a user decides to swap 50,000 DAI to 50 ETH from the pool. Following the swap, the liquidity pool will have 50 ETH and 150,000 DAI.

Meanwhile, let us assume an increased demand for ETH in the market drives its value by 2x to $2000 per tokens. At this time, if LP1 were to withdraw their staked assets, which is 10% of the pool value at that moment, they will receive 5 ETH and 15,000 DAI valued in total at $25,000.

If the person had held on to the assets without contributing to the pool, it would have been worth $30,000 ($20,000 in ETH and $10,00 in DAI). By contributing and withdrawing from the liquidity pool, LP1 experienced an effective impermanent loss of $5,000.

Those who provide liquidity for highly volatile assets are at a higher risk of losing value due to the occurrence of this phenomenon. However, by keeping in mind a handful of suggestions and playing it smart they can prevent the loss of any value or at least minimize it.

Ways to Avoid Impermanent Loss

Liquidity providers can make use of multiple options provided by DeFi platforms to minimize the magnitude as well as risks of impermanent losses. Some of the tried and tested strategies include participation in yield farming, providing liquidity for stablecoin pairs or low-volatility pairs, opting for flexible pool ratios and single asset liquidity provisioning.

Yield Farming

The best form of defense is offense and LPs can be on the lookout for farming programs offered by the same protocols offering the liquidity pools. By farming the proceeds received from the pools, they can bag considerable yields that are often large enough to offset impermanent losses whose occurrence can sometimes be inevitable. A risky strategy, it is something that seasoned investors should give a try.

Stablecoin Pairs

For those wanting to play it safe, staking stablecoin pairs is the way to go. As the name suggests, the value of stablecoins remains mostly constant albeit for minor fluctuations at times. The absence of volatility with such token pairs makes the chances of dealing with impermanent loss quite low (very slight fluctuations in the value of these coins do occur sometimes).

As the least risky way to provide liquidity, one can expect to earn profits from trading fees depending on the demand for these tokens.

Low Volatility Pairs

The returns on liquidity provisioning for stablecoin pairs may be on the lower end and the next best alternative is participation in pools consisting of low-volatility crypto pairs. At a slightly elevated risk potential, users can stake their assets in such pools being assured of minor price variations between each other. They can choose to invest in those pairs that exhibit similar price fluctuations, in the same direction to evade potential losses.

Flexible Pool Ratios

For those with a greater risk appetite and keen on providing liquidity for assets that are on the more volatile side, liquidity pools that offer flexible ratios balance out the risk. Pools in popular AMM DEXs like Uniswap follow the 50:50 ratio and keep the total value of the pool constant using algorithms. However, such ratios are known to cause impermanent losses frequently.

Instead, pools where one asset has a huge weightage as compared to the other reduces and can prevent such losses. For example, certain DEXs consist of popular pools that allow users to stake token pairs at 80:20, or even 98:2 ratio. re of the ratio 80:20 or even 98:2. Any impermanent loss experienced is minimal and can be easily offset by transaction fees.

Single Sided Liquidity Pools

Pools with flexible ratios like 98:2 prevent users from facing greater exposure to the volatility of two different assets at the same time. A new breed of DEXs led by Bancor – the first protocol to deploy the AMM algorithm providing for single sided liquidity pools, followed closely by InstaDEX on Tezos ecosystem take liquidity provisioning to the next level by allowing LPs to stake and maintain complete exposure to one single asset.

Such protocols also offer protection from the impermanent loss incurred with single asset liquidity provision- a great incentive to provide liquidity to the platform. Therefore, LPs can hold their assets in the pool for long periods of time, generating passive returns in the form of trading fees, staking rewards, and compounding yields.

Investing in Single Sided Liquidity Pools

Liquidity providers can begin to invest in single sided liquidity pools by staking a volatile asset. Meanwhile, as a market maker, the protocol or other users co-invests an equivalent amount of its native tokens and charges fees on its stake until the LP withdraws their asset at which point the co-invested tokens are burnt.

The fee collected is used by the protocol to cover any impermanent loss that LPs face in these pools. Moreover, LPs can also stake these native tokens that they own on the other side of the single asset provision pools. These tokens replace those staked by the protocol which are burnt.

Single Asset Liquidity provisioning pools on InstaDEX– the first platform on the Tezos blockchain to offer Bancor like features allows users to stake any asset of their choice on the relevant liquidity pool for efficient utilisation of the user’s portfolio.

Further, the impermanent loss protection insurance offered by InstaDEX covers LPs from potential impermanent losses after a minimum staking period of 100 days. The insurance fills the difference in value of assets in case of impermanent losses during the time of withdrawal to ensure the LP doesn’t lose any value by contributing to the ecosystem.

Conclusion

Impermanent loss is a by-product of all the advantages offered by DeFi. In the existing conventional AMM structure, it may be unavoidable, but there are always options available for consideration to minimize or overcome it.

With InstaDEX, Instaraise has devised single asset staking and impermanent loss protection insurance as a way to ensure the community is encouraged for their efforts and not penalized by forcing them to accept impermanent loss under volatile market conditions.