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Projects weigh security risks, benefits of liquidity pool token collateral

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A number of decentralized finance (DeFi) initiatives are transferring ahead with plans to permit liquidity supplier tokens as collateral for stablecoin and lending providers — although consultants warning that the safety concerns related to utilizing LP tokens on this method might be advanced. 

LP tokens are distributed to liquidity providers on automated market makers (AMMs) to characterize a supplier’s stake in a liquidity pool. Suppliers are incentivized with buying and selling and protocol charges which are paid out upon withdrawal.

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Whereas they’re typically the final cease in a cycle of yield farming transactions, a number of DeFi platforms at the moment are contemplating utilizing them as collateral, together with MakerDAO, Aave, and BadgerDAO — a transfer that might “maintain the cycle going” for yield farmers, in accordance with BadgerDAO’s Chris Spadafora.

One other step within the cycle

“When teams like us are in a position to say, “Oh, you’ll be able to unlock this illiquid place, and borrow towards it so you’ll be able to go and take further methods […] that is the place it will get attention-grabbing,” he mentioned in an interview with Cointelegraph last week

BadgerDAO is planning to launch a stablecoin — present neighborhood hypothesis is that it is going to be named CLAWS — that liquidity suppliers will be capable of declare towards their LP collateral.

The potential advantages of unlocking this liquidity are vital — and never only for particular person merchants. Jordan Gustave, the COO at lending platform Aave says that it may develop the ecosystem and inflate figures like DeFi’s closely-watched total value locked (TVL).

“The DeFi TVL may develop as a lot as persons are prepared to lend out to LP tokens collateral customers, which means that if I’ve sufficient liquidity to make use of my ETH/WBTC as collateral, then one may go simply 3x lengthy on the LP token and use the extra liquidity to farm UNI / Sushi / [Balancer],” he mentioned.

Further dangers

Nevertheless, in accordance with Tarun Chitra, founder and CEO of DeFi threat evaluation agency Gauntlet.Community, utilizing LP tokens as collateral prompts particular concerns depositors and platform designers want to remember. 

“It is sensible when the lender controls one of many belongings (e.g. Maker permitting leverage on ETH/DAI LP shares), because the leverage ratio is transparently identified the lender. It does additionally make sense whenever you need to make extra advanced derivatives, however you must be far more cautious.”

Chitra defined a worst-case situation wherein LP tokens may result in cascading, deflationary liquidations throughout the DeFi ecosystem. On this case, “LP token debt defaults, LP tokens are liquidated, reducing liquidity in some pair, making direct liquidations dearer” in a seamless cycle.

Spadafora and Gustave additionally each warned of further dangers surrounding oracle assaults, a subject that Aave explored in-depth after they selected to permit Uniswap v1 collateral, going as far as to develop a singular value discovery mechanism that values the underlying belongings within the liquidity pool in Ether.

“Not all LP tokens are appropriate (as collateral), the identical means not all tokens are appropriate. You simply want to use twice as a lot diligence as there’s basically two tokens to evaluate within the course of,” mentioned Gustave.

Gustave added that an Aave neighborhood member, zer0dot, has collected sufficient proposition energy in governance to push ahead a Uniswap market that may help v2 tokens as collateral on Aave.

As with MakerDAO and Badger, the Aave proposals look like tremendously well-liked and can doubtless transfer to implementation shortly.

Extra liquidity, extra safety

Regardless of the extra layers of sensible contract threat and accompanying safety considerations, Spadafora thinks they will finally be managed with correct due diligence and neighborhood religion. 

“Sure it does improve threat however once more it comes all the way down to the platform. Longer tenor, safety posture and repute matter essentially the most,” he mentioned.

In the meantime Chitra, who has researched the economics of liquidity provision extensively, urges warning and says that the frenzy of initiatives utilizing LP tokens as collateral might be worrying.

“A number of protocols appear to implement it haphazardly and that is nerve-wracking. Maker is the one place that appears to be diligent about their LP share borrowing.”