On May 28 an announcement was made by Uniswap market on its launch stating that it lets holders of specific liquidity tokens use them as collateral to borrow crypto assets from the protocol.
What do you get when you cross a unicorn with a ghost? 🦄👻 The new Aave money market: The Uniswap Market! 💫🌟👏 Check out our latest blog post by @JordanLzG to learn all about the first of many markets to come @UniswapProtocol https://t.co/GNNIqjdcXh — Aave (@AaveAave) May 28, 2020
Each liquidity token represents ownership in a Uniswap liquidity provider pool, and can be redeemed for the actual tokens at any point.
Liquidity providers receive a portion of the trading fees acquired by the Uniswap protocol, making it one of the many ways of earning passive income through DeFi.
However, liquidity tokens cannot be borrowed meaning that no additional income is received when depositing these tokens on the Aave platform.
Stani Kulechov, Aave’s CEO, says that this will be enabled later on, effectively letting users receive interest from two protocols at once.
However, an interesting use case of the system is opening leveraged liquidity pool positions.
As the liquidity pools can be inflated through borrowed money, Ave writes, this will:
“greatly reduce decentralized exchange slippage.”
To be economically feasible, trading fees would need to counterbalance the interest rate on the loan and the potential issue of impermanent loss.
Since, trading fees and interest rates are variable, this could result in a complex interactions between the two protocols as economic equilibria shift.
Nevertheless, the loan-to-value factors for these tokens were set to fairly conservative thresholds of below 70%, putting a limit to the maximum obtainable leverage.
Aave addresses the risk by correct the pricing of these liquidity tokens.
Very cool to see @AaveAave launch multi-market support today starting with @UniswapProtocol and soon @SetProtocol 🦄@StaniKulechov and team have a next-level understanding $ETH composability. It won't be long before the $LEND ecosystem extends to all of the #DeFi markets… pic.twitter.com/GA4SyHJmVz — Spencer Noon (@spencernoon) May 28, 2020
As these are fully synthetic tokens whose values are algorithmically derived by the underlying assets. Failures in Uniswap could threaten the Aave system as well.
The developers created an independent contract that would independently derive the value of the token based on the amount of underlying assets within the Uniswap contracts.
However, in certain circumstances deviations from the price of a token on Uniswap and the actual market price can still occur (which Aave assumes to be an attack on the platform)
Using Chainlink oracles to calculate the “true” value of the liquidity pools becomes the primary valuation method during these discrepancy periods.
Kulechov says that Aave applies a specific risk framework to prevent instability, noting that the interdependencies are:
“not that different from the exposures in traditional finance.”