Stablecoin Liquidity Pools: Minimizing Risks and Maximizing Gains

Key Takeaways

• Stablecoin liquidity pools enable liquidity providers to earn fixed yields by staking pairs of stable assets.
• Some of the largest stablecoin liquidity pools are available on Uniswap and PancakeSwap.
• The key problem with these pools lies in the centralized nature of the stable assets they support.
• For a stablecoin liquidity pool to be truly secure, it should support self-custodial wallets and truly-decentralized, fully-backed stable assets.
• Stablecoin liquidity pools may impose the risk of impermanent loss in case of the depegging process.

What are Stablecoin Liquidity Pools?

Stablecoin liquidity pools are very much like traditional liquidity pools where cryptocurrency holders can put their tokens to work. Yet, they support only stablecoins. 

This reduces the risk of impermanent loss and makes rewards predictable. At this, they represent the next stage of DeFi protocols’ development.

How Do Stablecoin Liquidity Pools Work?

Stablecoin liquidity pools work in the following way. They enable their users to earn yield while staking stable crypto assets such as USDT.

At this, they rely on the same principles as traditional liquidity pools do. Yet, since they only support stablecoins, they represent a much more reliable source of passive income than those that operate with volatile assets.

In a nutshell, the process of yield farming looks as follows:

1. Liquidity providers (LPs) stake a pair of stablecoins of equal value into the pool.
2. Traders use this liquidity to execute transactions on a decentralized exchange (DEX).
3. LPs earn a portion of the trading fees from every deal in the form of LP tokens.

The rewards one may earn in stablecoin liquidity pools are usually lower than in traditional liquidity pools that involve staking volatile assets.

Yet, the predictability of these rewards is something that makes such pools really attractive for automated market makers (AMM).

Biggest Stablecoin Liquidity Pools

As the concept of liquidity pools is still relatively new, the number of viable options is not very big. Still, there are already a few solutions that one may consider.

Uniswap

At the time of writing, a decentralized exchange Uniswap features some of the largest stablecoin liquidity pools by the size of TVL. 

As the platform operates with ERC-20 tokens, it supports some of the popular stablecoins such as DAI, FRAX, or USDT that are built on top of this standard.

At the time of writing, USDC remains the most popular asset with DAI/USDC being the largest stablecoin liquidity pool so far.

PancakeSwap

PancakeSwap is another DeFi ecosystem aiming to accumulate liquidity and enable AMMs to make passive income via yield farming.

USDC/USDT is the most viable liquidity pool on this platform. There is one more pair of stable assets, USDC/DAI, but its trading volume is much lower.

Are These Stablecoin Liquidity Pools Centralized?

While the platforms that feature such pools are decentralized themselves, it’s difficult to say the same about the assets that they offer for staking. 

USDT and USDC, two of the most popular stablecoins that one may stake in these pools are fiat-collateralized. 

This means that there is a single entity standing behind each of these projects that issues a new coin for every US dollar that arrives in their bank account. Therefore, there is always a counterparty risk that investors should be aware of.

Best Stablecoin Liquidity Pools

If you want to find the best stablecoin liquidity pool to stake your assets, pay attention to the following characteristics:

1. Decentralization. The pool should support those stablecoins that are not subject to counterparty risk. At this, algorithmic stablecoins such as USDL or LUSD that rely on automated smart contracts represent a good option.
2. Self-custody. A truly decentralized liquidity pool should support custodial wallets so as not to enable its users to fully control their assets.

There are many options to participate in stablecoin liquidity pools on PulseChain.

First, you can provide liquidity for pairs such as USDL:DAI, USDL:USDC, or USDL:USDT

Secondly, you can use the Stability Pool of the Liquid Loans Protocol which is in itself a stablecoin liquidity pool.

Stablecoin Liquidity Pool Risk: Impermanent Loss

Investors may experience impermanent loss when one of the assets in the trading pair drops in price with respect to the other.

As mentioned earlier, stablecoin liquidity pools reduce the risk of such loss. Yet, they do not fully eliminate it.

Impermanent loss may happen if a stablecoin depegs and doesn’t restore its price.

Alas, history knows a lot of such examples. 

Terra’s UST collapse in May 2022 is, perhaps the most prominent of them all. Not only did this popular algorithmic stablecoin fail its users. With the domino effect, it also initiated a series of other stablecoins’ crashes in the following months.

Why do such collapses happen at all and how can regular users protect themselves?

Well, there is no such thing as 100% safety in crypto. Yet, there are a few aspects that one can look out for when making research.

1. Redemption mechanism. The failed stablecoins lacked such a mechanism that would otherwise help them maintain their peg.
2. Insufficient collateral. Another problem with UST and other failed stablecoin was that they were undercollateralized. Thus, when the panic-sell began there simply were not enough coins to meet the demand.

At this, an algorithmic stablecoin should be overcollateralized and come with an automated redemption mechanism to maintain its rate in any circumstances.