How LP tokens can be integrated into a lending system
Decentralized exchanges have the highest Total Value Locked compared to any other protocol category in DeFi. The second place is occupied by lending protocols, of which Fringe is a burgeoning member. However, despite liquidity undoubtedly favoring these two leading DeFi markets, as DeFi currently stands, there are unique opportunities that can be leveraged to make the most out of their intersection.
In an Automated Market Maker (AMM model), best represented by the likes of Uniswap and SushiSwap, the capital deposited by liquidity providers (LPs) on pools is mirrored in their wallets as LP tokens, also called “pool shares.” These tokens represent ownership of a percentage of the total balance of a liquidity pool.
As the proportion of the token pair constantly shifts with trades, LP tokens are the most effective way to represent someone’s slice in the pool, and allow users to trade them freely. Redeeming one’s pool balance destroys the corresponding amount of liquidity tokens.
On some DEXs, LP tokens are standard ERC-20 tokens. Others, like the most popular DEXs, Uniswap v3 and its clones, use NFTs as liquidity provider tokens. Even in these cases, however, there are solutions for composability that involve wrapping the non-fungible liquidity tokens into ERC-20 equivalents.
LP tokens can be transferred, sold, bought, and used throughout DeFi. Nevertheless, today the actual number of possibilities for deploying LP tokens toward the DeFi ecosystem is scarce.
LP tokens and DeFi
Liquidity mining is currently the most widespread method to take advantage of LP tokens’ composability potential. In simple terms, liquidity mining is the action of offering rewards to liquidity providers that contribute to liquidity in a specific pool. Liquidity mining programs set up an interface to allow staking LP tokens for rewards.
Liquidity mining programs serve several functions, ranging from simply enhancing liquidity available for a project’s governance token (minimizing its volatility and making it more widely available for big purchases) to enabling fixed-interest markets to function well. Although the benefits of liquidity mining programs for projects launching them highly depend on why and how it is deployed, rewards often do work to attract liquidity providers.
Even though it has been tried, lending backed by LP tokens is still underexplored. The few options currently out there lack safety mechanisms for safeguarding stability and platform solvency. This is where Fringe Finance comes in.
Unlocking LP tokens’ value is an auspicious bet
It seems clear that enabling loans backed by LP tokens would be a fruitful endeavor. Just the set of Uniswap V2 LP tokens Fringe would be able to list in the Primary Lending Platform already represents hundreds of millions of dollars in locked, unexplored value.
As LP tokens are highly underexplored, their capital is even more deeply locked than typical altcoins. Through overcollateralized loans, Fringe will allow liquidity providers to access stablecoin capital with no need to close their LP positions. This enables them to participate in other DeFi opportunities or to increase their exposure to the liquidity pool’s yields through leverage. Additionally, this allows them to optimize their capital while continuing to receive income from platform fees.
Projects that actively provide liquidity to specific pools (for example, project $PROJ might provide liquidity to the PROJ/ETH pool) also have an interesting use case. They would be able to liberate the value in their LP tokens and use it to cover operational costs, R&D, and other investments without removing any of their liquidity. This is especially valuable in a bear market such as the current one, as it means projects do not have to unwind their LP positions nor sell their governance tokens, so long as their loan positions remain suitability overcollateralized.
When it comes to Fringe Finance itself, exploring an underserved segment is not the only reason to follow this path. DeFi is infinitely composable and highly dynamic; it creates a vast sea of possibilities. Integrating exotic assets gives the development team insights and familiarity that is invaluable when it deems necessary to integrate other novel instruments of higher complexity as collateral in the future.
So, how do we make it happen?
Integrating LP tokens into a lending platform is, in principle, reasonably straightforward.
The value of a token is proportional to the value of the assets it can be redeemed for, and the available liquidity is a function of the liquidity of the underlying pair of assets. The liquidity of the LP tokens themselves can safely be disregarded. It is almost immaterial, given they can be redeemed for these underlying assets, which would typically be much more liquid. The effect of impermanent loss has to be accounted for, something that must be reflected in the LP token’s Loan-To-Value Ratio.
However, to turn this into a reality, there are a few outstanding challenges to tackle. The platform must build a price feed that, considering the price and ratio of underlying assets, precisely calculates the redeemable value of the LP token. Additional gas fees required for liquidating these tokens must be assessed and offset in each asset’s Liquidator Reward Percentage.
We have not fully assessed three-sided LP instruments, but the same issues apply as for two-sided/paired liquidity pools. The apparent differences are that liquidators potentially have an additional underlying asset to dispose of.
After these obstacles are conquered, Fringe Finance would be able to promptly whitelist any LP token of interest into the Primary Lending Platform. This scenario represents a special milestone as Fringe further differentiates itself from its competitors and cements its deserved renown as an innovator in the DeFi landscape.
DeFi for Everyone.