Understanding the Evolution of the Four Key Financial Terms in DeFi: Liquidity, Leverage, Risk, and Arbitrage

This article is sourced from Medium, authored by Justine Humenansky, a partner at the investment firm Playground Ventures, and compiled by Echo and Gu Yu.

The development of DeFi has been rapid, with various innovations based on composability emerging one after another, yet there are still traces to follow and reasons to attribute.

The investment firm Playground Ventures pointed out in a Medium blog post that liquidity, leverage, risk, and arbitrage are the main factors driving the development of the DeFi market, and elaborated on how DeFi protocols have evolved from these perspectives. Chain Catcher has translated this article and made edits that do not affect the original meaning.

Although DeFi is still in the experimental stage, it has matured significantly since I first wrote about it in June 2019. With DeFi protocols gradually launching V2 and V3, I have re-examined the industry and how it has developed. After years of working in finance, I realized that most factors influencing the DeFi market can be summarized into four fundamental financial elements: liquidity, leverage, risk, and arbitrage. This article outlines the evolution of the logic of the DeFi market through these lenses.

This article outlines financial primitives, which are the core building blocks of financial markets, distinct from software or crypto primitives. It assumes that you have a certain understanding of finance, crypto, and DeFi, so the introduction to the protocols is not comprehensive.

1. Liquidity

Almost all factors can be attributed to liquidity, yet we consistently underestimate its importance. Higher liquidity leads to smaller slippage and greater market efficiency. Lower liquidity exaggerates market movements and amplifies sell-offs. It creates a flywheel effect during upward movements and a cliff effect during downward movements.

V1 DeFi protocols relied on a liquidity vacuum of constrained capital. The term constrained capital refers to capital that is locked in protocols and not fully utilized, leading to inefficient allocation.

This results in opportunity costs, as that capital could have earned higher returns either within or outside the protocol. V1 DeFi protocols relied on exclusive capital: MakerDAO required a minimum collateralization rate of 150%, lending protocols had not yet accepted over-collateralized assets (an innovation led by Compound in V2), and Uniswap's liquidity had low allocation efficiency across all price curves.

The opportunity cost of constrained capital has expanded alongside DeFi, and now V2 and V3 are striving for higher capital efficiency.

• As collateral for liquidity

Stablecoins play a significant role in DeFi. Fiat-backed stablecoins have many issues, such as centralization, regulation, and potential competition from CBDCs, while crypto-collateralized stablecoins are the most viable option. However, V1 DeFi relied on over-collateralization to maintain its peg to the dollar, which hindered scalability.

Many of the latest stablecoin iterations (FEI, OHM, FLOAT, FRAX) utilize Protocol Controlled Value (PCV). This is a concept where the collateral backing the stablecoin cannot be redeemed by users but is owned by the protocol (which decides whether/how to invest it, can use it to restore the peg, etc.). This is similar to a treasury or insurance fund, but unlike those, PCV can be immediately converted into liquidity (AMM pools).

Setting aside issuance issues, FEI's PCV makes it the largest liquidity provider (LP) on Uniswap. AAVE V2 similarly blurred the lines between collateral and liquidity, allowing borrowers to repay debts with existing collateral. Liquidity proofs have created similar dynamics for staking derivatives, which will be discussed in more detail below.

DeFi V1 addressed how to use liquidity as collateral (LP tokens). V2 and V3 protocols are exploring how to convert collateral into liquidity.

Unfortunately, relying solely on liquidity does not ensure stability. The real reason for the collapse of stablecoin systems is a crisis of trust under the pegged exchange rate regime. Addressing the constrained capital issue is not enough. Over time, sound economic mechanisms are needed to keep stablecoins near their pegged levels, and designing these mechanisms is challenging. Purely algorithmic stabilization mechanisms (Basis Cash, Empty Set Dollar) have struggled, as these mechanisms require users to maintain confidence in future pegging mechanisms.

The so-called direct incentives, which penalize trades that deviate from the pegged exchange rate and reward trades that maintain it, ultimately withdraw liquidity from the system at the most critical moments. Harsh sell-off penalties mimic constrained liquidity and tie up more capital, which is the problem we initially sought to solve.

Other models attempt to address the confidence issue first and improve capital efficiency over time, starting with fully collateralized tokens that allow market dynamics to adjust collateral ratios. As confidence grows, capital efficiency will also improve.

FRAX employs this model but currently has the backing of a basket of fiat-backed stablecoins. While this mechanism seems to be working, it remains unclear how it will sustain itself if it is entirely backed by unregulated assets.

While the latest generation of stablecoins focuses on lowering collateral requirements, we need to address the confidence issue in the pegging mechanism before improving capital efficiency.

• Liquidity as a liability

When discussing liquidity, we cannot overlook the dominant Uniswap. Uniswap played a crucial role in the rise of liquidity mining, which, in turn, significantly influenced Uniswap's trajectory. After we painfully realized that liquidity is not a moat, the focus shifted from acquiring liquidity to retaining it.

Competitors began to advance, adding higher moats/margin services, such as lending (Kashi Lending), borrowing practices from traditional fintech: acquiring users cheaply and upselling credit products.

Instead, Uniswap fundamentally rethought the liquidity mechanism for asset management, resulting in v3, which can increase capital efficiency by up to 4000 times in special circumstances.

While AMM V1 was an innovation from 0 to 1, their efficiency was also low because they required liquidity for prices that might never be reached. For example, if ETH is within a $200 range and there is $10 million in the ETH/DAI pool, the liquidity pool for buying ETH below $10 or above $5000 could be as high as 25%.

In this example, the likelihood of needing liquidity at those levels is minimal. Maintaining this constant price curve leads to lower trading volumes (~20%), as $5 billion of locked capital corresponds to only $1 billion of trading volume.

The uniform distribution of liquidity across the entire range also means that little liquidity is concentrated in the most traded areas. Curve recognized this early on and created AMMs specifically for stablecoins that trade within narrow ranges.

Uniswap v3 addressed these issues and, in the process, came closer to limiting the single price, as LPs can now specify the price range for providing liquidity (e.g., ETH/USDC from $1800 to $2200). This change should lead to almost all trades occurring within the range near the midpoint price, thereby improving liquidity where it is most needed.

More concentrated liquidity also reduces asset risk. For example, if an LP bids $500 for ETH/DAI but is confident that the price of ETH will rise, they are exposed to the risk of holding an unwanted asset (DAI) (the opportunity cost of ETH). Uniswap v3's concentrated liquidity allows LPs to significantly increase their exposure to preferred assets, thereby reducing this risk.

Balancer V2 also attempts to reduce inventory risk by introducing asset managers, allowing LPs to lend one side of the trading pair's assets without using them as trading liquidity. Yearn's Stablecredit employs a similar function.

Next-generation asset management systems require less capital but will bring more liquidity.

• Liquidity trading

Super-liquid collateral is a V1 concept that refers to the ability to tokenize locked assets (collateral or liquidity) to obtain liquidity or leverage on that asset. Staking derivatives extend this concept to staked assets (assets securing proof-of-stake networks) by allowing users to deploy staked assets more effectively elsewhere.

Proponents of staking derivatives argue that without these derivatives, the liquidity of staked tokens would be affected. There are concerns that if validators can obtain higher returns from DeFi protocols, they will not be incentivized to stake tokens.

In theory, staking derivatives could raise the staking ratio of ETH from 15-30% to 80-100%, as they eliminate the additional costs of staking compared to not staking.

Staking derivatives also allow for the creation of new financial instruments. For example, cash flows "guaranteed" by proof-of-stake rewards can make products resemble interest-bearing bonds (Terra's bAssets, Blockswap). These tools can be used to generate sustainable, stable, relatively high yields (like Anchor Protocol), which may attract more mainstream users to support DeFi.

The uniqueness of staked assets compared to collateral is that they are not just a payment commitment but a security mechanism. Some designs, particularly those that allow staking derivatives to move across chains, enable risk conversion (from endogenous to exogenous), which may impact the fundamental game theory that helps protect public networks. In contrast, liquidity proofs convert staked tokens into the liquidity of underlying network tokens in a way that balances capital efficiency and network security, which should be a primary priority.

2. Leverage

Leverage amplifies returns (the ultimate result of capital efficiency) but also magnifies losses. Establishing leverage is easy, but controlling it is difficult. We love leverage until we hate it.

Traditional financial markets have collapsed countless times due to excessive or hidden leverage. In just the past six months, we have seen the market impact of Archegos's high leverage and Gametop's short-selling leverage (with Gametop's 140% circulation being shorted).

In the cryptocurrency market, we have seen $10 billion liquidated in the past 24 hours, partly due to a chain reaction of leveraged long liquidations. This is a stress test for the crypto market, and some DeFi protocols are under significant pressure.

• Creating leverage

The DeFi summer of 2020 saw a frenzy of activity largely driven by aggressive leveraged strategies in liquidity mining. Although this activity has since subsided, we are beginning to see new leverage mechanisms emerge. Element's yield token is one example.

When users deposit collateral through Element, two tokens are generated: the principal token and the yield token. Suppose a user deposits 10 ETH at a 20% annual interest rate; the user can sell their principal token at a fixed yield rate of 10%, receiving 9 ETH while maintaining exposure to the interest on the full 10 ETH over time through the yield token.

Afterward, the remaining 9 ETH can establish a new position, repeating the operation to achieve leverage rates of up to 6.5 times. The ability to earn interest on the full principal and the net present value of obtaining a loan is unique compared to earlier lending protocols.

While some protocols aim to achieve under-collateralized loans in DeFi, they are primarily conceptual. Although CREAM V2 strives to achieve protocol-to-protocol uncollateralized loans through Iron Bank, it is only available to whitelisted partners, with parameters directly determined by the CREAM team, highlighting current limitations.

In contrast, Alchemix approaches this issue from a completely different angle, allowing borrowers to benefit from over-collateralization. For example, a user who deposits 1000 DAI can access 500 alUSD. By putting 1000 DAI into a Yearn vault to earn yield, that yield can be used to repay the loan over time.

Another option is to first purchase $500 and then invest the unspent $500, which would obviously yield less than the $1000 (yielding $280, assuming a 25% annual interest rate over two years, resulting in $280 less). Similarly, borrowers can earn interest on the full principal while still benefiting from the discounted portion of the principal.

New lending protocols leverage the time value of money and the separation of principal and yield, allowing users to benefit from (over) collateralization.

• Complexity of cross-collateralization

While the early DeFi ecosystem primarily relied on circularity priced in one asset (ETH), V2 expanded the complexity of lending protocols by allowing multi-collateral systems.

In this system, m types of collateral can be used to borrow n assets, with single-collateral DAI evolving into multi-collateral DAI, and Compound supporting cross-collateral currency markets, while Aave and CREAM expand by supporting an increasing number of assets. Yearn's StableCredit protocol allows users to create synthetic debt positions, essentially swapping collateral (a feature supported by AAVE V2 through flash loans).

Some protocols go further by centralizing all asset risk exposure, dispersing counterparty risk among users. On Synthetix, when the value of any synthetic asset minted in the protocol increases, it raises the total debt value in the system, while users' ownership of the total debt pool remains unchanged. This could lead to an increase in users' debt balances due to price increases of assets to which users have no direct exposure.

This complexity of cross-collateralization and cross-asset exposure improves functionality but also increases the potential for market contagion, where a sell-off of one asset may trigger sell-offs of other assets.

• Controlling leverage

Composability enables rapid innovation, but it also means that DeFi Lego blocks can quickly become a house of cards. Although on-chain transparency exists, it is difficult to create a unified view of cross-protocol aggregated leverage, meaning there is currently no simple way to understand the ratio of commodity credit to liquidity credit, which impacts the system's solvency.

In a system without a lender of last resort, solvency is particularly important. Additionally, while centralized venues liquidate underwater collateral themselves to avoid counterparty risk, decentralized protocols rely on third-party liquidators to eliminate underwater debt from their balance sheets. These liquidators can choose to purchase underwater collateral from the protocol at a discount, but due to volatility, network congestion, or other market factors, they may also choose not to purchase.

Liquidity attempts to address this issue by creating pools of funds available for liquidation. In this model, LPs agree in advance that their liquidity will be used to purchase collateral at a discount during liquidation. While this allows protocols to lower loan collateralization rates to 110% and offer 0% fixed rates, LPs may ultimately purchase collateral due to price declines, incurring higher costs.

3. Risk

In finance, there is an inevitable ratio: risk/reward. It is simple to understand: higher returns correspond to greater risks, and breaking this ratio is very difficult.

When the market is new, risk is often represented in binary terms: to risk or to hedge. As the market matures, there is a better understanding of the composition of risk, and risk transfer mechanisms develop, forming a sliding scale that allows market participants to express their individual risk tolerance.

• Binary risk

Volatility products give market participants a binary view of market risk and are an essential component of market infrastructure. The volatility index represents the market's estimate of future volatility and is a cornerstone of traditional financial markets. The CeFi market has offered some VOL products (FTX MOVE), but the DeFi market has almost none. Protocols like Volmex are working to create volatility indices, while the Benchmark protocol's stablecoin uses VIX as an input for its stability mechanism. Index Coop seems to be a natural candidate for an inherent volatility index in DeFi, and Opyn has also expressed interest in creating a "DeFi VIX."

• Floating risk

Emerging DeFi protocols are developing "risk-matching engines" to pair market participants with lower risk tolerance with those with higher risk tolerance. Most projects achieve this through multi-token systems that separate the speculative and non-speculative aspects of the protocol and redistribute cash flows accordingly (Saffron, BarnBridge, Element).

For example, Element separates principal and yield, allowing users to purchase the net present value of the principal (essentially a zero-coupon bond) or take on leverage of up to 10 times the yield. BarnBridge divides cash flows into fixed and variable yields. Holders of variable yield receive higher returns than fixed-rate holders but subsidize fixed-rate token holders in the event of a gap.

Similarly, Saffron divides risk into senior and junior tranches, with senior bonds offering lower yields. Higher yields = higher risk.

These programmable risk protocols support peer-to-peer risk transfer and allow users to bet on different parts of the capital structure. Risk-averse capital (like corporate finance departments) may prefer to purchase senior products, while yield-chasing speculative traders may prefer junior products. Enhanced risk tolerance is a positive development for the DeFi market, and tiered trading itself is not inherently dangerous.

4. Arbitrage

Arbitrage is essential for the normal operation of many DeFi protocols, and the design of any protocol must consider arbitrage. Uniswap heavily relies on arbitrageurs to maintain price discovery. Some believe that MakerDAO's scale is limited due to the infeasibility of arbitrage CDPs. Yearn's StableCredit relies on arbitrage rather than governance to maintain system stability.

1inch, Yearn, ParaSwap, and Rari can all serve as arbitrage tools. ThorChain and Serum will be key to achieving cross-chain arbitrage as DeFi protocols launch across layer 1 blockchains.

As DeFi scales, reducing gas costs will provide a temporary arbitrage opportunity, which is increasingly shaping the V2/V3 designs of DeFi protocols (Aave V2 collateral trading, dydx's gasless orders, Balancer V2 pooled assets, Sushiswap's BentoBox).

V1 focused on cross-protocol arbitrage, while V2/V3 focuses on cross-chain arbitrage.

Arbitrage improves market efficiency (the extent to which market prices reflect all available relevant information) but also leads to narrower spreads and normalized yields, eliminating temporary advantages between protocols. As market efficiency improves, competition also increases. To maintain dominance in this environment, genuine protocol innovation is needed, not just incrementalism.

V2 and V3 DeFi protocols will need to innovate across all four financial primitives, as their interrelated nature drives market factors. Without arbitrage, stablecoins cannot expand. Without liquidity, there is no capacity for arbitrage. Leverage allows you to take on more risk, while risk transfer enables you to take on more leverage.

Importantly, DeFi supports entirely new financial primitives, such as flash loans, which have no traditional counterparts. Protocols that solve all these primitives and/or create new ones will lead the next generation of DeFi development.

I can't wait to see V4 and V5.