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

23 Nov, 2022

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.