Liquidity for Adults: A Practical Taxonomy
This article is part 3 of my “Liquidity for All” series.
Liquidity in DeFi is a completely different beast than in CeFi. I would call the former an algorithmically-rebalanced hybrid asset, while the latter is essentially fiat cash that is earmarked for investment or another purpose.
If you read parts 1 and 2 of this series, you should have a good idea of the motivation for providing balanced liquidity to a “pool”: to facilitate trading between the two underlying assets. Anyone who swaps between these assets must pay a small fee to the liquidity “providers” who enabled this trade. Such liquidity “positions” are most commonly manifest as “LP Tokens”, which represent a liquidity providers’ fractional share of the pool and its associated rewards.
It is crucial to understand that such LP tokens are not the sum of their parts: they follow their own set of rules and behaviours. LP token are instruments that combines (at least) 2 assets, so the behaviour and value are entirely dependent on which assets constitute the position.
This article will explore liquidity positions using live market examples, and propose a taxonomy that contains 7 “classes” and 3“types” of liquidity.
Classes: Backbone, Stablecoin, Exposed, Index, Correlated, Volatile, Ape
Types: LP Tokens, Leveraged LP Tokens, Freeform
Classes of Liquidity
I define “Backbone” tokens as the native token of a live blockchain network: primarily Ethereum but potentially Binance, Polygon, Solana, Cardano, Fantom, Terra, Harmony, Avalance, etc. Each network has its own DEX, which generally contains several liquidity pools with the backbone token and a prominent stablecoin such as USDC, USDT, bUSD, UST, etc.
Uniswap — ETH
PancakeSwap — BNB
Quickswap — MATIC
Raydium — SOL
Adax — ADA
ViperSwap — ONE
TerraSwap — LUNA
Ubeswap — CELO
“Backbone Liquidity” is LP tokens that consists of one backbone token and one stablecoin. The price exposure is tied to a widely used and high-market-cap blockchain network, which is subject to volatility but will not “tank”. Such pools are extremely popular since they serve as a gateway between stable and backbone crypto assets.
In my opinion, the only viable backbone networks at this time are Ethereum and to a lesser extent Binance Smart Chain. Other networks such as Polygon, Solana, and Terra are still establishing themselves while the broader market engages in price discovery. Nascent blockchains such as Cardano and Celo are at early developmental stages, but could provide appealing alternatives in the future.
In the past few years, numerous stablecoins such as USDT, USDC, DAI, MIM, bUSD, cUSD, UST, TUSD, etc. have emerged to provide a stable store of value tied to the US Dollar. Each coin has a unique utility: USDT is leveraged for cheaper Bitcoin transactions, USDC is ideal for Coinbase users, UST is used for payments in South Korea, and so forth. For this reason there is high demand to swap between stablecoins, which results in numerous liquidity pools to support trading.
Price consistency is ideal for liquidity providers: since reputed stablecoins experience negligible fluctuations around $1 dollar, there is minimal price exposure and divergent loss. For example USDT-USDC LP rebalancing could result in more USDT and less USDC, but functionally they are both worth $1.
As mentioned at the start, the price exposure of liquidity positions entirely depends on the underlying assets. Backbone liquidity with one stablecoin and a “top 10” cryptocurrency is relatively less volatile. If you replace the backbone token with that of a less-known more-volatile DeFi project such as Raydium (RAY), a promising Solana DEX, the larger price movements lead to increased divergence. Hence the name ‘exposed’ liquidity, where 1 side experiences unpredictable volatility.
As DeFi continues to grow, there is increasing interest in “index” or “basket” products that provide managed ETF-style exposure to multiple assets. The most prominent indexes are Defi Pulse Index (DPI), and perhaps Coindesks DeFi Index (DFX) which have comparable holdings (including Uniswap, Aave, Compound, Maker, Yearn, Synthetix, and other usual suspects). Newer products such as Bankless BED Index (BED) and Total Crypto Market Cap (TCAP) provide other innovative strategies that track the market, while thematic products such as the Metaverse Index (MVI) provide exposure to a specific “sector”.
But in the current state of crypto, most DeFi projects are mortally dependent on Ethereum and often have strong price correlations. Ether is the #2 cryptocurrency by market cap, and has an estimated 20% market dominance as of August 2021. Since Bitcoin and Cardano cannot yet host smart-contract based DeFi projects, this 20% market dominance would more than double when only considering the “decentralized app” (dApp) ecosystem.
With this in mind, one might surmise that the prices of Ethereum and index products consisting of ETH-hosted DeFi projects would not drastically diverge, which is optimal for liquidity positions.
As mentioned with Index funds, most DeFi projects have varying degrees of price correlation with their host blockchain network. This extends beyond Ethereum to Binance, Solana, Terra, and other future blockchains. For instance during the recent Solana bull run and selloff, most dApp utility tokens such as Raydium (RAY), Synthetify (SNY), and Rope (ROPE) experienced sympathetic price movement with SOL. Bear in mind these assets are independent of the Ethereum blockchain and had weaker correlation with ETH or associated dApp tokens.
Price correlation is difficult to quantify or rely on in DeFi, but platforms such as MacroAxis provide useful tools to estimate historical correlation. Per their analysis, ETH and AAVE have a 87% correlation, while ETH and UNI have closer to 90%. Providing liquidity between two moving assets can be risky, as we will soon explore, but this correlation between backbone and associated dApp tokens should remain strong.
I define this as LP tokens consisting of two non-stablecoin assets such as ETH-SOL or RAY-ATLAS. Price divergence between the two assets can be disastrous for liquidity positions, which is why such risky pools have high swap fees are often incentivise providers with additional rewards. Volatile liquidity positions must be carefully timed and managed, but can provide outsized returns if strategically handled. This is far from a “set-and-forget” investment like stablecoin liquidity. But remember: we are betting on trading volume, not just price gains. Volatility can be more than welcome in liquidity land.
Nearly all DeFi startups needs to crowd-source funds towards development and “liquidity bootstrapping”. Consider a metaphor of a new water amusement park: entrepreneurs have created attractions (dApps) such as water slides and rafting rides using land and license provided by the local municipality (blockchain). Before this park can properly function, it requires a lot of water to fill up the rides. This is where startup liquidity comes to the fore.
In order to attract investors to stake funds into their platform, many startups offer absurdly high Annual Percentage Yield (APY%) to compensate investors for the risk they assume with early stage volatility. Most of these pools start with low Total Value Locked (TVL) which does not inspire investor confidence, so convincing liquidity providers to temporarily “stake” their funds into the platform creates a cyclical confidence effect that helps the project take off. Most tokens allocate these rewards and incentives into their “tokenomics”:
Investing in early stage projects, especially those that have not yet been audited, is a highly risky proposition. This is why certain thought leaders in the industry call this strategy “Ape-ing in”: moving funds into small pools (low TVL) with appealing incentives (high APY, additional rewards) during their initial launch phase. If the project survives, these early incentives inevitably dry up and the APY dwindles to more sustainable values over time, at which point many retail or “ape” investors swing to a more lucrative liquidity mining opportunity.
Types of Liquidity
- LP Tokens
So far we have discussed 2-sided liquidity pools, and investments in the form of “Liquidity Provider” (LP) tokens using funds you presumably own. This is type 1, and is by far the most common model across various blockchains. But there are several other models and methods to optimize liquidity throughout DeFi.
2. Leveraged LP tokens
For bulls who want to avoid wasting their funds in stablecoins, “Leveraged Farming” allows investors to enter liquidity pools by borrowing stablecoins against a collateral asset, then pooling and depositing the LP tokens. Such positions can be liquidated if the value of the collateral falls below a certain threshold, but could conversely provide outsized returns if the price moves in the right direction. Alpha Homora is the primary destination for such adventures in the Ethereum world, and newer platforms such as SolFarm have designed their entire product around this.
Liquidity is not always a two-way street: some platforms have developed mechanisms for users to safely pool between 1 and 8 assets. Bancor allows users to pool 1 asset in a 2-sided liquidity pool by constraining the amount of incoming deposits or “Space Available”:
On the other side of the spectrum, Balancer pools can contain up to 8 assets with a preset distribution, which is rebalanced by arbitrage traders. Investors can pool an arbitrary amount of any of these assets, and earn proportional rewards from swap fees on the pool.
We have come a long way from swapping fictional Coins and Rupees on the Nintendo Exchange. Liquidity is to DeFi what water is to humans — we simply can’t live without it. As this article hopefully illustrates, liquidity is more of a instrument type than an asset class, since the underlying assets wholly dictate the behaviour of the liquidity position. The proposed taxonomy encompasses most of the possible liquidity configurations in DeFi today.
In the next article, we explore Uniswap’s incredible v3 upgrade and the dawn of “Non-Fungible Liquidity”, as well as the Olympus DAO model where projects can “own” their own liquidity instead of relying on whimsical Ape investors like myself. Head to part 4 “Liquidity for Pros: Non-Fungibility and Bonding” here.