Shower thought: Liquidity pools are like the opposite of collateralized borrowing

That is, compare:

– a liquidity pool with two tokens, A and B, versus
– putting up token A as collateral and borrowing B against it (e.g. through Compound, so A gets seized if the loan to collateral ratio gets too low.)

**Liquidity pool (LP):** Accumulate fees over time.
**Collateralized borrowing (CB):** Accumulate debt (interest charges on loan) over time.

**LP:** Your invested capital gets the returns of the lower-performing token (impermanent loss).
**CB:** Your invested capital get the returns of whichever token performs better. (if A skyrockets, you pay back B and keep the returns of A; if B skyrockets, you keep it but lose A).

**LP:** Invested capital falls to zero if either token falls to zero.
**CB:** If one token falls to zero, you keep the value of the other.

Not saying one or the other is better, but it implies that you could use one to cancel out the other, right?

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4 thoughts on “Shower thought: Liquidity pools are like the opposite of collateralized borrowing”

  1. Kinda sorta.
    Collateralized borrowing is essentially taking a long or short position. Put up dollars to buy AVAX is a bet that price of AVAX will go down. Rationale being that if price goes down, you can spend fewer dollars to repay the AVAX you’ve borrowed.

    If you borrow dollars against your AVAX, you’re betting that price of AVAX will go up, enabling you to buy more dollars with fewer of your AVAX in order to repay the dollars.…so one fundamentally makes or loses the most money when the asset pair diverges.

    In an LP, you make the most money when asset prices converge. Coins A and B go in opposite directions and you lose more money. Coin A increases at a greater rate than Coin B and you haven’t made as much money as you could have by holding the two separately. Conversely you might not lose as much money as you otherwise would have holding the two separately.

    In a liquidity pool, the fundamental bet is that regardless of whether A and B go up or down, the pair will track closely and therefore a larger volume of people will swap between the two and therefore the more fees you’ll make.

    So an LP is itself the hedge whereas borrowing can be used to adjust your exposure one way or another within the hedged position.

    Imperfect analogy: think of an LP as a scale where the weights are constantly shifting from one side to the other. Your borrowing positions are the thumbs you can put on the scale to try to balance it out.

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  2. Very interesting thread! Small nitpick:

    >LP: Your invested capital gets the returns of the lower-performing token (impermanent loss).

    If you invest in a pool with 2 tokens A worth $100 and B worth $100, and after some time A rises to $200 and B rises to $150, your assets will be 73.2% if you provided LP and 75% if you held. That’s a 1% difference, on a pretty big price divergence. That’s what an IL calculator will tell you. but this assumes that nobody used the pool and you gained 0 trading fees.

    Your profits aren’t equal to the returns of the lower-performing asset, they’re a function of trading volume (fees).

    As you mentioned you are affected by price divergence, but it’s not really a loss. If you use a covered call options strategy, are you experiencing “impermanent loss” by not simply YOLOing with naked options?

    LPing gives you certain rewards (fees) at the cost of some uncertain rewards from price appreciation.

    >you could use one to cancel the other, right?

    Yes! You can supply DAI to a lending protocol, use it as collateral and borrow ETH. If you’re right and the price of ETH falls your debt will decrease and you’ll have more free collateral. You benefit from the price of ETH decreasing and now have some free collateral that can use to borrow / buy more ETH.

    This lets you crate a short position. All LP positions are inherently long both assets (unless the assets are some weird leveraged short synth)

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