- Ease of Access: Easy-to-access liquidity in a clear, transparent, and frictionless set-up.
- Income Generation: Generate interest income by supplying the idle collateral as liquidity to the pool.
- Strategy Implementation: Borrow collateral quickly without needing to swap the existing collateral to a new pool.
- Automated Governance: Fully automated mechanism with transparent rules applicable to all objectively.
What Are Borrow Lending Pools?
Borrow Lending: Borrow lending pools enable the use of liquidity to meet the financial needs of borrowers and lenders (suppliers) to efficiently open positions, close positions or generate income.
Pool Lending: Pool lending refers to lenders (suppliers) depositing funds into a liquidity pool.
Pool Borrowing: Pool borrowing refers to borrowers who can open a position (borrow from the pool) using another crypto asset as collateral.
This borrow-lend arrangement is governed by the exchange rules on how much liquidity is allowed to be borrowed based on the supplied amount and the interest owed by borrowers to suppliers for facilitating the liquidity. The liquidity pools are designed for each token separately like USDC, USDT, SOL, BTC, ETH etc.
Benefits of using Pools:
Below are some of the benefits of pool lending for lenders (suppliers):
Liquidity: Lenders can withdraw funds anytime since the funds are pooled.
Income: By allowing the idle collateral to be lent to the pool, the lenders can generate additional income in the form of interest payments from borrowers
Diversification: One can easily lend to multiple borrowers to reduce their risk of default and diversify across borrowers.
Governance: From funding the pool to distributing interest payments, the pool mechanism is automated, transparent, and governed by exchange rules,
For borrowers, the liquidity pool offers the following benefits:
Ease of Access: As long as your account is in good standing, borrowers can instantly access the funds to finance their needs without any approval.
Interest rates: Interest rates for borrowing from pools may be lower than other options.
Trade Implementation: If the account has a different collateral asset than the one you want to use as collateral, you don’t need to sell the existing asset. Rather, use the pool to borrow the asset for implementing your strategy.
How Do Liquidity Pools Work?
The Liquidity pool used on the exchange is typical of a Shared Lending Pools, as seen in AAVE. Typically, it pools funds from many lenders into a single smart contract. Borrowers can then take out loans from this pool, with interest paid to the lenders.
The downside of depositing funds into concentrated pools is less control and visibility into fund allocation. Having multiple large borrowers default can also quickly create a snowball effect of cascading liquidations.
However, this model is often favored by the general user base for its simplicity. It boasts high liquidity, easy and convenient access to capital, and potentially low rates for borrowers. It algorithmically ensures fairness based on supply and demand.
A Closer Look at Interest Rates
Before using the liquidity pool, it’s important to understand the interest rate on the assets borrowed and how interest paid on the assets supplied is calibrated.
Let’s break down the dynamics first. When there is excess demand, the price of the goods goes higher. Similarly, when there is excess supply, the price of the goods goes lower.
Lend-borrow works similarly; when the supply of liquidity is higher than the demand for liquidity, the rate of liquidity (interest rate) goes lower and vice versa.
The interest rate algorithm is calibrated to manage risk for the pool participants, and support the user incentive to provide liquidity to the pool thereby optimizing utilization of the liquidity in the pool. T
- When capital is available: low interest rates to encourage borrowing.
- When capital is scarce: high interest rates encourage borrow repayments while incentivizing additional supply.
The interest rates for borrowing and supply are derived from a parameter called Utilization Rate, which will be described in the next section.
What is Liquidity Pool Utilization Rate?
Utilization Rate represents the availability of capital within the pool. It’s calculated using the ratio of the amount of liquidity borrowed and the amount of liquidity supplied. For example,
Suppose we have a SOL liquidity pool and there is 1000 SOL that is currently supplied into the pool by various lenders. In addition, 300 SOL amount has been borrowed from the pool. Interest is paid on that amount. Thus the current Utilization Rate of the pool is:
Utilization Rate (UR) = Token Units Borrowed / Token Units Supplied
UR = 300/1000 = 30%
The higher the Utilization Rate, the higher liquidity in the pool has been utilized and liquidity available is lower. Similarly, the lower the Utilization Rate, the liquidity available is higher since the liquidity utilized will be lower.
How is Lending Pool Interest Rate Calculated?
Interest rate algorithms for finding the borrow and supply rates are automated and based on model parameters.
Borrow rates: refer to the interest rate the borrower will owe to suppliers of the pool for supplying liquidity.
Supply rates: refer to the income rate that suppliers will receive from the borrowers who pay the borrow rate.
If there is only one lender and one borrower, then the borrower must pay the interest directly to the lender. In this case there is no distinction between supply and borrow rate.
But with multiple borrowers, multiple suppliers and varying amounts, we must distinguish between borrow rate and supply rate. Borrow rate will be akin to cost of financing the loan quickly from the pool that applies to all borrowers equally.
Borrow rates will be high or low depending on demand for liquidity. The interest being paid by borrowers is distributed across all suppliers. As such, the more there is lent into the pool relative to the borrowed amount, the less interest income there is to be distributed and thus the rate paid to lenders is lower. When the lent amount is close to the borrowed amount, there is more interest income relative to supply and thus lenders receive a higher rate.
For Example:
If there are 10 suppliers supplying 100 SOL into the pool then the overall supply is 1000 SOL. Now, let’s suppose 300 SOL has been borrowed at a 10% borrow rate. This means 30 SOL is paid in interest.
But who should the interest paid go to?
Since this is a shared lending pool, the rate needs to be distributed proportionally among all the liquidity suppliers. Hence the lending (supply) rate would be closer to 30/1000 = 3%.
Notice that as the amount of borrow increases from the pool, the borrow rate keeps increasing. Thus the interest distributed amount increases as well, thereby increasing the supply rate for suppliers.
Interest Rate Parameters
The interest rate algorithm uses the following parameters currently:
The “Base Borrow Rate” is the rate when Utilization is 0%, and the “Variable Slope 1” determines how the rate of increase in the borrow rate as liquidity in the pool is used for borrowing.
The “Optimal Utilization Rate” is the utilization rate at which the slope of the interest rate curve will be shifted to a steeper one (Variable Slope 2). This refers to the concept of higher borrowing rate as the liquidity in the pool gets used up. This drives demand for liquidity and encourages suppliers to supply further liquidity to the pool.
Given the utilization rate (U) of the liquidity pool, the borrow rate is calculated using:
If U < Uopt Borrow Rate = B0 + S1* (U / Uopt)
If U > Uopt Borrow Rate = B0 + S1 + S2* (U - Uopt) / (1 - Uopt)
Given the utilization rate (U) of the liquidity pool, the supply rate is calculated using:
Supply Rate = U * Borrow Rate * (1 - Protocol_Fee)
The protocol fee is the % fee charge on the interest rate income that is charged by the exchange and fees are supplied back into the pool as additional liquidity.
Rate Calculation Example:
Let’s suppose the SOL liquidity pool is set-up with the following parameter values:
Uopt = 60% B0 = 0% S1 = 40% S2 = 85% Protocol_Fee = 15%
And currently, the pool has 1000 SOL liquidity supplied and 30 SOL borrowed liquidity. This means the current utilization rate is 30%.
Borrow Rate = 0% + 40% * (30 / 60) = 20%
Since 30% is currently lower than optimal utilization rate of 60%
Supply Rate = 30% * 20% * (1 - 0.15) = 5.1%
Now, let’s suppose the 700 SOL has been borrowed, the current utilization rate is 700/1000 = 70%. The borrowing rate is now calculated as:
Borrow Rate = 0% + 40% + 85% * (70 - 60) / (1 - 60) = 61.3%
Since 70% is currently higher than optimal utilization rate of 60%
Supply Rate = 70% * 61.3% * (1 - 0.15) = 36.4%
The overall path of the borrow and supply rate for different liquidity pools look something like below:
Managing Risk when using Liquidity Pools:
Using liquidity pools comes with certain risks and must be used carefully. If you’re considering lending or borrowing liquidity from the pool, be sure to mitigate your risk by doing the following:
- Use Idle Collateral: Use collateral to trade instruments opportunistically.
- Leverage: Increasing leverage by borrowing can increase your chance of account liquidation.
- Be Mindful of Parameters: All liquidity pools parameters need to be reviewed and understood prior to using the pools. High utilization rates can mean high-interest payments.
- Diversify: Diversification can help spread risk. Instead of supplying liquidity into a single pool, whenever possible you should consider supplying liquidity to different pools
- Stay Informed: The cryptocurrency market is highly dynamic and easily influenced by market sentiment which can quickly increase or decrease the utilization in the pools. Staying informed on how such changes can affect parameter updates, borrow limits, etc.
Closing Thoughts
Whether you're a seasoned trader trading perpetual futures or a crypto newcomer learning about crypto whales, lending pools offer an easy and flexible way to tap into liquidity. But remember, in trading, as in life, there's no reward without risk—so trade wisely and start slowly with dollar cost averaging if you’re just getting started.
Disclaimer: This content is presented to you on an “as is” basis for general information and educational purposes only, without representation or warranty of any kind. It should not be construed as financial, legal, or other professional advice, nor is it intended to recommend the purchase of any specific product or service. You should seek your own advice from appropriate professional advisors. Where the article is contributed by a third party contributor, please note that those views expressed belong to the third party contributor, and do not necessarily reflect those of Backpack. Please read our full disclaimer for further details. Digital asset prices can be volatile. The value of your investment may go down or up and you may not get back the amount invested. You are solely responsible for your investment decisions and Backpack is not liable for any losses you may incur. This material should not be construed as financial, legal or other professional advice.
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