The professor is back!
Now it’s time for you to understand the concept of our Leverage Liquidity provisioning feature.
Introduction
In the evolving world of decentralized finance (DeFi), various innovative mechanisms are emerging to optimize capital efficiency and provide better opportunities for investors. One such innovation is the concept of leveraged liquidity provisioning.
This article aims to demystify leveraged LPs, explaining how they function, their benefits, and the risks involved, using a specific case study involving USDC and the ATOM/USDC pool.
What are Liquidity Pools?
Basic Concept
Liquidity pools are a fundamental component of DeFi, enabling decentralized exchanges (DEXs) to function without the need for traditional order books. They consist of funds locked in smart contracts, provided by liquidity providers (LPs) who earn fees in return.
If you want to understand how our pools work, read this article :
Introduction to Leverag Liquidity Provisioning
Concept of Leverage in Finance
Leverage involves using borrowed capital to increase the potential return of an investment (but also potential loss). In traditional finance, leverage is used to enhance the profitability of various financial instruments. In the DeFi space, this concept is adapted to liquidity provisioning.
Leverage LP
Leverage liquidity provisioning allow users to provide liquidity with borrowed funds, amplifying their exposure to the assets within the pool. This is achieved through protocols that offer leveraged positions within the pool, enhancing potential returns and risks.
How Leveraged Liquidity Provisioning Work
Mechanism
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Initial Deposit: Deposit USDC on the leverage LP page on our Webapp
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Borrowing: The protocol then Borrow USDC from the USDC staking pool, increasing the total amount of liquidity they can provide. The borrowed amount is based on the initial deposit and the leverage ratio chosen.
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Provision of Liquidity: The amount of borrowed funds is added to the liquidity pool.
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Earning Fees: The LP earns trading fees on the total amount of liquidity provided, which is higher due to the leverage.
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Repayment: The borrowed amount needs to be repaid with interest (over time), typically from the earned fees or by withdrawing liquidity.
Case Study: ATOM/USDC Pool with Leverage
Initial Deposit
A user deposits 200 USDC into the ATOM/USDC leverage liquidity pool.
Leveraging
Using a leverage ratio of 5x, the protocol lends an additional 800 USDC to the USDC staking pool (90% maximum of the pool for safety reasons). This increases the total liquidity provided by the LP to 1,000 USDC.
Earnings
Assuming trading activity generates fees, the LP earns fees on the entire 1,000 USD liquidity.
Assuming that the price of your LP is going up you will get a return also equivalent to your exposition if you want to withdraw your collateral.
For example, if you have a collateral value of 200 USDC for a balance of 1000 USDC with a leverage of x5 and the pair you're betting on gets +5%, you'll get 200+( 5% of 1000) = 250 USDC.
For example, if you have a collateral value of 200 USDC for a balance of 1000 USDC with a leverage of x5 and the pair you're betting on gets -5%, you'll get 200-( 5% of 1000) = 150 USDC.
Repayment
The user must repay the borrowed 800 USDC plus interest. If the fees earned and any change in asset value (ATOM price movement) are favorable, the user is in profit. However, if the value of ATOM drops significantly or fees are insufficient, the user could face losses.
In addition, interest fees must be paid, and these fees are paid directly to the USDC stakers. You can find out how this works in this article.
Benefits of Leverage Liquidity Provisioning
Enhanced Returns
The primary advantage of leveraged LPs is the potential for higher returns. By providing more liquidity than they initially possess, LPs can earn greater fees.
Increased Capital Efficiency
Leverage allows LPs to make more efficient use of their capital, potentially leading to higher overall liquidity in DeFi ecosystems.
Risks Associated with Leverage Liquidity Provisioning
Impermanent Loss
Impermanent loss, a risk in traditional LPs, is amplified in leveraged LPs. It occurs when the value of deposited assets changes relative to each other, potentially leading to losses when withdrawn. (only for our Fixed weighted pools)
Liquidation Risk
If the value of the LP’s assets falls significantly, the protocol may liquidate the position to repay the borrowed funds, causing a loss of the initial deposit.
Interest Rates
Borrowed funds accrue interest, which can reduce overall profitability if not managed properly.