What are liquidity pools? Latest news on stablecoin LPs

Investors lost out after stablecoin depeggings. But what does it mean for liquidity pools?

Dollar bills swirling into a void, symbolising money losses                                 
Millions drained from LPs due to stablecoin fallout in 2022 – Photo: Shutterstock
                                

Contents

What is a liquidity pool?

Hopefully, by the end of this article you’ll have all the answers to the what are liquidity pools and how do liquidity pools work. Essentially, a liquidity pool – commonly abbreviated to LP – is a core component of the decentralised finance (DeFi) ecosystem. Traditionally, exchanges acted as the market makers, providing the liquidity needed for traders to buy and sell crypto assets. Since liquidity was held by a single entity, Binance, Coinbase, FTX and others, which act in this way, are referred to as centralised exchanges (CEXs).

The launch of Uniswap provided an alternative to this centralised method. Instead of the exchange, individual users could provide liquidity, thus the decentralised exchange (DEX) was created. Since then, DEXs have multiplied. One of them, Curve Finance, is the primary DEX for stablecoin trading on Ethereum and Ethereum Virtual Machine (EVM) compatible blockchain networks. On a DEX, liquidity providers are incentivised via staking rewards in the form of an annual percentage yield (APY) sourced from transaction fees.

Screenshot of Pool3 assets
Curve’s Pool3 consists of the DAI, USDC and USDT stablecoins – Credit: curve.fi

Each DEX is slightly different, but the process of depositing into a crypto liquidity pool generally involves connecting your wallet, choosing the pool you want to contribute to and how much you want to commit. Theoretically, you should see passive income start to roll in, but contributing to stablecoin LPs does not come without risk. If one stablecoin permanently loses its peg – an event that the Terra blockchain demonstrated in May 2022 could happen at any time – liquidity providers could find themselves holding a large bag of worthless cryptocurrency.

Staking rewards are never guaranteed. Although APY is always cited, percentages are not fixed and are usually lower than expected. Lastly, LP actions are executed via smart contracts, which are subject to security risks and cannot be upgraded.

Analysing Curve Finance’s 3Pool

3Pool is Curve’s largest LP with $1.4bn on total value locked (TVL) and daily trading volumes in the hundreds of millions. The last 24-hour trading volume was $198.1m (on 19 May). The LP comprises three stablecoins: DAI, USD Coin (USDC) and Tether (USDT).

Screenshot of 3Pool’s blend
Low risk means low yield – Photo: curve.fi

The above screenshot shows that 3Pool’s reserves are a blend of: DAI (12.45%), USDC (12.68%) and USDT (74.87%).

Regardless of which cryptocurrency a liquidity provider chooses to stake into the LP, value will be distributed in relation to this blend. For exampke, if you are staking 100 DAI into 3Pool – 12.45% goes to DAI, 12.68% to USDC and 74.87% to USDT. Therefore, you gain exposure to all three stablecoins when depositing into 3Pool, regardless of which coin you stake. Once deposited, you receive 3Pool LP tokens of equal value to the amount you deposited, which can later be redeemed for your deposit.

Screenshot showing bonus for depositing DAI
Bonuses are used to rebalance asset blend to equal amounts – Credit: curve.fi

Although your deposit gets divided among the pool, Curve provides an incentive for depositing the stablecoin with the highest value on the exchanges (invariably the asset with the lowest pool share, since traders tend to rush to sell for a profit). The above screenshot shows a 0.091% bonus for depositing DAI. The blend of 3Pool constantly shifts up and down due to a complex trading process called stablecoin arbitrage.

As the largest of Curve’s pools, 3Pool’s APY is low. The current minimum estimate is 0.253% with a 0.631% maximum. This is because liquidity utilisation is only 12.46%, meaning over 87% of liquidity is not needed. Lower demand means lower returns.

There is a 0.01% fee for staking on 3Pool, 50% of which goes to administration. The other 50% is used to pay APY rewards. Although 3Pool’s APY rewards are low, it could be a good option for beginners. While there are certainly still risks, highly liquid pools are safer in comparison to smaller pools.

The fall of 4Pool

Speaking of risks, Curve’s 4Pool crypto liquidity pool shows what can happen to a pool if one stablecoin loses its peg. 4Pool was created in April 2022 with backing from Frax Protocol and Terraform Labs – owner of UST under the leadership of Do Kwon –, two algorithmic stablecoin projects, the latter of which suffered one of the worst bankruptcies in cryptocurrency history.

In addition to FRAX and UST, 4Pool includes the fUSDT (a wrapped version of USDT on the Fantom network) and USDC asset-backed stablecoins. The intention was to make 4Pool among the largest stablecoin LPs on the Fantom blockchain.

As UST began its death spiral, traders rushed to exit their positions, leaving 4Pool overwhelmingly stuffed with UST. The latest pool distribution – as of 14:30 BST (UTC +1) on 19 May – is as follows:

  • FRAX: 146,462.94 (1.71%)

  • USDC: 146,198.39 (1.70%)

  • UST: 8,149,835.96 (94.89%)

  • fUSDT: 146,471.07 (1.71%)

UST may have been delisted from all major exchanges, but DEXs like Curve do not operate like that. 4Pool is a factory pool. In other words, it is a permissionless crypto liquidity pool and cannot be delisted. Naive buyers can potentially swap FRAX, USDC or fUSDT for UST, lured by a 1,200% exchange rate and encouraged by the assumption UST will repeg.

Screenshot of inflated exchange rate between FRAX and UST
Tempting exchange rates, but… – Credit: curve.fi

Not only is this wishful thinking, users run the risk of being stuck with tokens that cannot be redeemed.

Screenshot of exchange rate being to low to swap UST
…ultimately worthless – Credit: curve.fi

But even though factory pools cannot be delisted on Curve, there is a workaround. CurveDAO, the decentralised autonomous organisation responsible for governance of the Curve platform, is currently voting to remove all UST liquidity pool gauges (as of 19 May). The measure, which is likely to be voted through, will remove any incentive to provide UST liquidity, effectively making the 4Pool liquidity pool redundant.

UST’s failure continues to be assessed, but one thing is clear – the 4Pool liquidity pool looks set to be another casualty in the saga.

SCREAM

Fantom-based protocol SCREAM, used for lending and borrowing Fantom-compatible cryptocurrencies, is also suffering at the hands of depegged algorithmic stablecoins. 

According to The Defiant, traders have taken advantage of a flaw in SCREAM’s liquidity pool protocol that hardcoded the price of Fantom-native “stable”coins DEI and fUSD to $1, despite currently changing hands at $0.59 and $0.85 on the open market respectively.

As SCREAM failed to reflect DEI and fUSD’s depegged price on the platform, opportunistic traders managed to swap their overvalued tokens for other (genuinely) pegged stablecoins, effectively draining FRAX, USDC, USDT and other liquidity pools.

Working with the Fantom Foundation, SCREAM seems to have handled the situation via a series of liquidations and subsequent repayments.

Unfortunately, the event has caused a large drop in SCREAM’s TVL to $36.94m from $171m one week prior (as of 19 May). TVL was as high as $1bn in February. The SCREAM token is faring just as poorly.

Graph of SCREAM’s declining TVL in 2022
SCREAM’s TVL has reduced significantly in 2022 – Credit: defillama.com

Once again, the situation shows the weaknesses and dangers involved with stablecoin liquidity pools. Recent events have shown that algorithmic stablecoins are far from stable, and the effects of depegging are felt far and wide. Depositors risk being locked out of their funds.

In summary

Stablecoin liquidity pools have their nuances, but operate in largely the same way as PancakeSwap LPs – users provide liquidity in return for APY rewards. The recent turmoil in the algorithmic stablecoin space has had a knock-on effect for a number of protocols, including SCREAM and the largest stablecoin DEX Curve Finance.

Having liquidity pools explained and understood is essential before interacting with the DeFi space and while passive income can be earned, you should also be aware of the risks involved. Always do your own research before locking your money up in a liquidity pool.

FAQs

Depositing into liquidity pools comes with risks. The protocol could become insolvent or a smart contract could fail. If an asset tanks in value, you could be left with worthless tokens. Rewards are never guaranteed and are subject to fluctuations.

First determine what crypto you have at hand or are willing to purchase and lock up. Then research which decentralised exchanges are available on your crypto network – PancakeSwap on BNB Chain, Uniswap on Ethereum, etc. After that, you should assess what your risk tolerance is. Shallower liquidity pools generate healthier rewards, but are also riskier. Always be careful with your money and bear in mind that you could lose your stake.

You can earn passive income on liquidity pools by locking tokens up for a predetermined duration. APY is distributed among liquidity providers depending on quantity staked.

Furthermore, liquidity providers are lent an LP token that can be used for yield farming protocols and subsequently redeemed. Be careful as your position could be liquidated or you could encounter impermanent loss when locking your funds into a liquidity pool.

Liquidity pools make money via transaction fees that are then distributed among liquidity providers. 

Further reading

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