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An Analysis of the Various Models of Liquidity Pools within DeFi and how USD+ Compliments Them

TL;DR Liquidity Pools have been evolving rapidly within DeFi. There are different models the likes of Uniswap and Curve that facilitate the seamless trading of volatile tokens (BTC, ETH) and stablecoins (USDC, USD+) respectively. However, the inherent flaw of the model is that they merely amass TVL and a lower trading volume along with low yields makes the model capital inefficient. This is resolved via the use of USD+ in such liquidity pools that generate more yields and volume for Liquidity Providers relative to other stablecoins (e.g, USDC). The article below explores each of their models and makes you aware of how Liquidity Pools work behind the scenes.

Introduction

Frictionless Liquidity Pools are gaining prominence by the day in DeFi. Risk-averse yet high yields are widely preferred within the space and those with lower APYs (Annual Percentage Yielded) are deemed as “redundant.” As Yield-Farmers are constantly on the search to maximize their returns from Liquidity Provisions, the model itself has an inherent flaw which we’ll explain more on towards the end of this article.

Let’s dive into the inception of Liquidity Pools via Decentralized Exchanges, their evolution, and how we came to know of them currently in our write-up.

Starting a revolution within Ethereum: Uniswap

It all started in November 2018 when Uniswap was deployed on the Ethereum blockchain. At the time being, Ether Delta was the only Decentralized Exchange (DEX) on the chain yet its clumsy UI and limit-order format rendered it messy and came across as unintuitive to the wide majority of users.

A look into Ether Delta
A look into Ether Delta

It was with the aid of an Automated-Market-Maker (AMM) and a clean User Interface (UI) that users began preferring Uniswap over the former, Ether Delta. Uniswap adopted an approach whereby participants traded against a Liquidity Pool as opposed to bids set out by other users.

Ethereum possessed a strong sense of resentment towards centralization and censorship; it was with Uniswap that the fundamental ethos of the blockchain was championed — decentralization, censorship-resistant, permissionless and open source were some of its most appealing features.

Uniswap enabled frictionless trading between a pseudo-anonymous userbase whereby to interact with the dApp all you needed was an Ethereum-compatible wallet (Metamask, Trustwallet, etc) and an active internet connection.

This accessibility and appeal to the masses had users flocking to trade on the DEX and provide liquidity for their pairs of choice — Ethereum being the most popular token on Uniswap. Before we knew it, a decentralized infrastructure was established with immutability within a trustless environment — all you had to rely on were Ethereum miners to process your transactions and the Smart Contracts to execute it which were open-sourced.

Uniswap’s model involved the use of the infamous XYK (X*Y=K) mathematical formulae that the Market-Maker used for calculating the weightage of Liquidity Pools. The idea was to have the contract hold X & Y tokens respectively and consistently maintain the constant that X*Y=K (where K is a given constant). A given Liquidity Pool strictly consisted of 50/50 tokens whereby two tokens (X & Y) were provided by Liquidity Providers at a pre-determined, precarious ratio enforced by smart contracts. The weightage of both constants was then affected by buys & sells as they occurred — refer to the graph below.

The X*Y=K formulae being plotted on a graph
The X*Y=K formulae being plotted on a graph

As more of one particular token was bought, its prices increased relative to the Liquidity Pool it was paired via and arbitrage bots maintained a steady flow of prices within the AMM for these tokens.

Liquidity Providers were incentivized to provide Liquidity to earn a 0.3% swap fee for all trades. At the time, there were no alternative Yield-Farms and ways to grow your portfolio massively — it was either provide liquidity on Uniswap or have your tokens sit idle in your wallet.

Owing to the unique offerings provided, within 2 years of launch, Uniswap managed to support $20Bln in volume, had 250,000 unique addresses interact with the dApp, and secured over $1Bln in Liquidity deposited. It has readily been the DEX of choice on Ethereum for trading volatile token pairs.

Introducing Curve — built specifically for stablecoin swaps

Okay, Uniswap’s surged in prominence, you get the idea. Why do we need “another DEX” when Uniswap’s permissionless, trustless, and all of those ideals made it the biggest DEX we came to know of?

Well, remember the XYK mathematical formulae that we previously talked about? Here’s the problem; the change in quantities of X tokens subjects to an increase in the price of Y tokens. Consider this, imagine you’re swapping stablecoins and you see a 2% price impact. That’s inconvenient, right?

As a matter of fact, that’s exactly why Curve was launched — laying down a stablecoin infrastructure that has now expanded to 10 chains and counting. For a stablecoin to remain stable, it is essential that those large trades are executed with minimal slippage and minimum deviation from peg — this is where the stableswap comes in.

Without diving into too much detail, the Curve.fi model uses an invariant model — unlike Uniswap — that is optimized for stablecoin trading at minimal slippage. This means that large trades will have a significantly lower effect on the slippage when made around its peg.

Stableswap formulae plotted on a graph
Stableswap formulae plotted on a graph

Therefore, as the above image portrays, a stableswap is a mixture of Uniswap’s X*Y=K formulae (which we’ll refer to as the product invariant) with the addition of X+Y=C (which we’ll refer to as the sum variant) whereby C equals $1.

However, what if stablecoins are unbalanced and face a depeg situation coupled with cascading sell-offs? Well, then the invariant becomes a product invariant instead of the sum invariant, and hence swapping then becomes expensive like an exchange.

With multiple tokens in a pool, the formulae has evolved to cope with the increase in token quantities. For example, the most prominent Curve pool is the a3crv pool which consists of USDC, USDT & DAI. Therefore, the product invariant in this case becomes X*Y*Z=K and the sum variant X+Y+Z=C (where constants X, Y & Z denote USDC, USDT & DAI respectively).

This innovation has resulted in Curve being the stablecoin trading platform of choice for many traders as the DeFi protocol offers the ability to trade millions in stables with minimal slippage through the combination of the StableSwap algorithm and deep liquidity in the Curve pools.

Curve’s growth has been exponential and the protocol averages a $200M daily trade volume — a feat like no other.

The image shows the effect of a $1M trade from DAI to USDC on Curve with extremely low slippage owing to Curve.fi’s stableswap model.

The best of both worlds: Solidly — a combination of Uniswap & Curve

Using Uniswap for swaps between Volatile Assets and Curve for swaps between Stable assets is inconvenient — can’t there be a single solution to the two? Well, Solidly did exactly this!

Launched by Andre Cronje — whom people widely considered as the man who started DeFi — Solidly set out to solve the inherent flaw that Curve had — i.e, prioritizing TVL over Trading Volume.

Solidly used the best of both worlds between Curve & Uniswap. It did this by offering the Uniswap V2 constant product AMM (X*Y=K) for volatile swaps and the Curve AMM (X*Y*Z=K) for stable swaps. This enabled users to come to a single dex for the most efficient trading experience regardless of swap type and created deeper liquidity in a unified protocol — no need.

What changed? Well, Andre Cronje left DeFi sending shockwaves within the space and causing the price of Solidly’s native token, SOLID to tank massively. Since then there has been little to no development on the AMM and it has largely died down.

However, Solidly lives on through Dystopia — a derivative of the AMM deployed on Polygon — with its unique take on the protocol that you can read here. The DEX has amassed popularity as enshrining a new generation Solidly AMM with bringing fundamental improvements to the concept such as tokennomics improvements, better routing, back & front-end refinement, etc. It is being used as the hub of Liquidity Provisions with its intention to also serve as a DEX aggregator.

Weighted Index Pools: Balancer and Boosted Tokens

What better combination than using Uniswap for trading volatile assets and Curve for stableswaps? Well, think again because innovation never ceases within DeFi. This time its Balancer introducing Weighted Index Pools and, introducing its infamous Mean Market Equation along with Boosted Tokens

What sets Balancer apart from others is that it enables users to create liquidity pools with up to eight different tokens (whereby this has been restricted to 2 by Uniswap) at a custom ratio. Balancer pools can be thought of as automatically rebalancing portfolios, wherein anyone can create or join a decentralized index fund and fees go to liquidity providers instead of intermediary fund managers. It can be compared to what’s widely known as an Index Fund within Traditional Finance whereby your investment is made in a set of diversified cryptocurrency assets — your portfolio is subjected to the performance of these underlying cryptocurrency assets cumulatively.

Unlike traditional index funds whereby liquidity pools are balanced manually, Balancer adopts an automated and a market-reliant approach. In doing so, arbitrageurs rebalance the pool’s desired weightage through swaps whilst accumulating trading fees for Liquidity Providers.

Balancer adopts its own unique invariant mathematical formulae for weighted and stable assets which are quite complex. To give you a basic idea, weighted math is designed for frictionless swaps between assets regardless of price correlation whereas stable math facilitates a 1:1 trade for pegged assets (DAI, USDC, wBTC, etc).

Another set of innovations by Balancer has been its Boosted Pools. Consider this, in most Liquidity Pools, only 10% of Total Liquidity is used to facilitate swaps whereas the remaining 90% acts as a reserve fund to facilitate low slippages. What if there was a way to optimize the remaining 90% of the liquidity that sits idle? Boosted Pools do exactly this!

Boosted pools deliver capital efficiency and this results in increased returns for Liquidity Providers allowing the protocol to amass more TVL. The excess liquidity is better managed via supplying assets on AAVE, Yearn Finance — etc. You can reap the benefits of boosted returns by using bb-a-USD pools; users earn BAL rewards and swap fees in addition to an extra boost from the underlying tokens being on AAVE.

Boosted APRs from bb-a-USD pools
Boosted APRs from bb-a-USD pools

Optimizing Liquidity Pools: The Magic of USD+

Now that we’ve given you a somewhat basic idea of how some of the most prominent Liquidity Pools operate within DeFi, we’ll go towards the matter at hand. Remember when we said Liquidity Pools have an inherent flaw?

Well, here’s the dilemma. Curve prioritizes TVL over trading volume activity whereas trades on Uniswap are capital inefficient. Balancer has innovated in this regard with bb-a-USD tokens; however, the APRs for such are extremely low — a mere 0.85% assuming the full boost — to be materially significant for Liquidity Providers. Moreover, Curve has also incorporated aUSD tokens by providing boosted yields via lending on AAVE; however, the outcome is the same as that of Balancer. Furthermore, any attempts to incentivize Liquidity Pools with excessive inflationary rewards are short-lived due to the inherent nature of such rewards.

How do you solve the dilemma of increasing trading volume whilst simultaneously providing low-risk lucrative yields on stables? The solution: USD+.

To start off, USD+ is fully collateralized by secure stablecoins — a combination of USDC, DAI & USDT — and pegged to USDC. The collateral is deployed across a spectrum of Liquidity Pools such as Dystopia and is fully redeemable for 1 USDC at any given point. Through partaking in Yield-Farming for Stable-to-Stable pools, USD+ generates considerably more yields than boosted tokens — currently amounting to 8–12% APY with all of the rewards being financed by the yield strategies. The user realizes yields from USD+ regardless of whether it is in Liquidity Pools or simply held as a stand-alone in their wallet.

How USD+ works when used in LPs
How USD+ works when used in LPs

This not only improves the concept of Capital Efficiency adopted by Balancer but also extends the concept to other DEXes. For example, Uniswap V2 and its derivatives (Quickswap, Dystopia, etc) are incompatible with boosted tokens and USD+ resolves this shortcoming.

Similarly, USD+ generates more trading volume (21% more than USDC as of currently) than vanilla-USDC owing to arbitrages maintaining a stringent peg for USD+ if/when large trades have an effect on the peg.

It is this innovation that sets a new precedent for Liquidity Pools that are currently centered around mostly inflationary rewards and USD+ removes reliance on such rewards partially. This as a whole is revolutionary and changes the way we Yield-Farm entirely.

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