What You Need to Know About Liquidity Pools and On-chain Borrowing

 

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In traditional finance (TradFi), lending and borrowing are facilitated by financial institutions that enforce interest payments and assess creditworthiness. However, in decentralized finance (DeFi), trust in third parties is replaced by trust in blockchain technology and smart contracts, enabling new on-chain lending mechanisms.

A lending pool is a smart contract that allows users to deposit assets, typically ERC20 tokens, to lend to others. Borrowers can take out instant loans by depositing collateral assets into the pool.

Compared to TradFi, DeFi lending pools have advantages like:

• Pools aggregate deposits from multiple users to accommodate on-demand loans, not limited 1:1.

• Loans are issued against collateral, so borrowers can repay flexibly, not on rigid schedules.

But why borrow assets in DeFi by providing equal or overvalued collateral? The answer is leverage trading.

For example, if you're bullish on Wrapped Bitcoin (WBTC), deposit WBTC into a lending protocol, borrow a stablecoin like USD Coin (USDC), and use it to buy more WBTC. This increases your WBTC exposure beyond your initial investment. You can use the additional WBTC as collateral to borrow more USDC and further leverage your position until you reach the protocol's limit.

Conversely, if bearish on WBTC, deposit USDC as collateral, borrow WBTC, exchange it for stablecoins. If WBTC drops as expected, rebuy it cheaper to repay the loan, and keep the excess USDC - effectively shorting WBTC.

To incentivize deposits, lending protocols pay interest over time as a percentage of deposits. As assets stay deposited, interest accruals increase.

Protocols use "pool tokens" to track users' shares without inefficient on-chain updates. Pool tokens represent a lender's share of deposits and adjust shares automatically when deposits/withdrawals mint/burn pool tokens proportionally.

Liquidity Bootstrapping Pools (LBPs) address the challenge of optimal token pricing for Initial DEX Offerings (IDOs). Instead of risky mispriced launches or private rounds, LBPs source initial liquidity and let the market set the initial price. This also reduces front-running and dilution risks.

LBPs like Copper Launch start with high token prices and initial liquidity. As more participants add liquidity, the price gradually falls until reaching market equilibrium. This approximates the market price.

Once set, the pool closes, funds can be reclaimed, and tokens distributed to seed trading. This lets early supporters buy at advantageous prices. However, some tokens distribute initially, so redeeming them counters front-running risks.

With potential unvested token circulation, LBP parameters must be set carefully. But overall, LBPs enhance efficiency and value creation in DeFi fundraising by determining appropriate prices while raising funds.

Despite challenges, LBPs are an innovative approach to token pricing and fundraising. By precisely and flexibly addressing investor and user needs, they have the potential to transform liquidity management in cryptocurrency.