What’s the greatest challenge facing the decentralized finance ecosystem? Improving user experience? Onboarding the unbanked? Actually, the biggest problem defi has faced up until now has lain deeper than that. It resides at the base layer, where one of the longest-running afflictions of decentralized protocols can be found: lack of liquidity.
Trustless token-swapping systems aren’t blessed with the deep liquidity enjoyed by centralized exchanges. When all trades are conducted on-chain, it’s virtually impossible to avoid slippage, high spreads, and all the other problems that are synonymous with low liquidity. Over the last two years, a solution has emerged in the form of liquidity pools. These aggregate pooled assets across multiple platforms and protocols, resulting in dramatic improvements in liquidity.
With Bancor, this is achieved using relays – pools where users store idle assets, which calls for acquiring a relay token. This represents a tokenized version of their stake. Every time a relay converts tokens, a fee is applied, part of which goes to the liquidity provider, proportional to their stake.
As with so many things in life, however, fixing one problem merely introduces another, or reveals one that had hitherto lain obfuscated. In the case of liquidity pools provided by the likes of Uniswap and Bancor, the issue was thus: providers suffer from a gradual loss of liquidity over time. This is on account of price variation in the underlying crypto assets, causing what’s known as the impermanent loss to liquidity pool providers.
Such losses are minimal, but over the course of enough trades, they start to add up. Uniswap has calculated a 1.25x price change in the underlying assets as resulting in a 0.6% loss to providers, rising to a 2% loss in the event of a 1.5x price change. The phenomenon is similar to a pendulum clock that loses a fraction of a second a day; over the course of time, these fractional losses take their toll. Pretty soon, you’re running slow – or running low in the case of liquidity providers. In the event of large price movements, liquidity providers can potentially lose more than they will make in the form of fees. How do you prevent loss caused by price movements in the underlying assets stored in a liquidity pool?
Solving this seemingly intractable problem has required time, resources, and the brainpower of some of the brightest minds in the space.
The Solution to Impermanent Loss
The solution has come, not surprisingly, from one of the leading liquidity pool providers. Having been active in the decentralized finance space since 2017 (before it had even assumed the defi portmanteau), Bancor knows more than most about pooled liquidity. Like Uniswap, its developers have been chipping away at the problem for a while, and in S2S pools they believe they’ve found a solution.
The S stands for “stable,” and Bancor’s new take on the liquidity pools mechanism facilitates Stable2Stable transfers, enabling providers to pocket 100% of the fees collected, with no impermanent loss. The solution to the problem which, like so many breakthroughs, seems obvious in hindsight, is to use stable assets on both sides of the swap. Specifically, to use stablecoins such as USDB (a dollar-pegged coin minted using BNT) to eliminate the problem of price volatility.
In a recent talk at Crypto DeFiance summit in Singapore, Bancor’s Nate Hindman explained the workings of the scheme, and predicted that “Stablecoins will play a key role in reducing impermanent loss & improving the profitability of liquidity pools.” To facilitate this, Bancor has created dedicated stable pools, where liquidity providers can add their USDB. S2S pools accept deposits as low as $2, and users can withdraw their accumulated fees at any time upon converting their pool tokens using the CoTrader portal.
What This Means for Decentralized Finance
Solving what seems, on the surface, to be a minor inconvenience, will have major ramifications for the growth of decentralized finance. For the industry to grow, it is vital that pooled liquidity can at least match and ideally outstrip demand, since deep liquidity is needed to convince the world that defi can compete with traditional finance and centralized crypto services alike.
If liquidity is key, maximizing the returns available to its providers is the oil to grease the lock. Fix that and you can unlock the door to an array of decentralized services from lending to derivatives. Automated market makers can be integrated into DEXs like Uniswap, Bancor, and YOLO, facilitating cross-pool and cross-chain liquidity spanning the Ethereum and EOS ecosystems.
Decentralized finance is all about reducing systemic risk: the risk of trusting third parties, including custodians, credit agencies and banks that are prone to freezing or seizing funds and shuttering accounts at a moment’s notice. But it’s also about reducing the risk to liquidity providers, the worker bees who perform a vital service and deserve remuneration for their efforts in bootstrapping the burgeoning defi economy. Through eliminating the risk of incurring losses through price movements in pooled assets, one of defi’s greatest problems looks to have been finally solved.