Saddle Finance: Liquidity Pool Considerations

Author: Shaun Geer (DancingPenguin) · Bankless Research · July 2022

Goals

• ·Structure and create liquidity pools in such a way as to minimize loss of TVL and risk in general.
• ·Attract new users through the onboarding of new assets or swap pairs.

Recommendations

• ·With assets that have a higher risk of depegging, structure liquidity pools so that contagion risks are minimized, for example, by not pairing two risky assets together.
• ·Use Coindix to calculate utilization ratios of various on-chain pools from Saddle's competitors to identify gaps in liquidity coverage.

Risk Management

With few exceptions, Saddle should accept any partner that allows TVL to increase, usually through some seed money or incentive arrangement. However, the structure of the pool should reflect the risk profile of the assets involved.

Key risk factors to evaluate for any new pool asset:

• ·Historical stability: While past stability is not a guarantee of future performance, it is a meaningful signal for collateralized stablecoins.
• ·Collateralization: Fully collateralized stablecoins are safer than partially collateralized ones. Stablecoins backed by liquid, on-chain assets are preferable.
• ·Ability to enforce market price: Crypto-collateralized stablecoins can face liquidation cascades during market downturns in a way that fiat-backed stablecoins do not.
• ·Regulatory risk: Centralized providers like Circle carry regulatory risks that decentralized stablecoins do not: this is a two-sided consideration.

As such, USDC or TUSD is slightly safer than DAI in terms of peg mechanics. During a recent market downturn, MakerDAO had to contact Saddle directly to manage risk in a shared pool: a scenario that structured pool design can mitigate.

Another risk mitigation strategy: automatically freeze a pool for everything except withdrawals if one asset drops below 50% of its peg. This limits contagion while allowing users to exit.

Evaluating Potential New Liquidity Pools

The Utilization Ratio Framework

One of the most useful tools for evaluating new pool opportunities is the utilization ratio: the amount a liquidity pool is being used relative to its total value locked. A high utilization ratio indicates strong organic demand for a particular pair, even if its absolute TVL is modest.

Coindix is an aggregator for DeFi investment opportunities that collects APR and TVL data across chains and protocols. Because liquidity pool fees send roughly 1.5% to liquidity providers, we can calculate throughput from APR and TVL:

• ·TVL = v
• ·APR = r
• ·Throughput (t) = v × r × (100 / 0.015)
• ·Utilization ratio (u) = r × (100 / 0.015)

By using throughput and utilization ratio, Saddle can identify pools that have outsized usage relative to their TVL: a strong signal that a new pool in that asset pair would attract real users, not just mercenary liquidity.

Generally, Saddle should aggressively explore partnerships with token providers that have high throughput compared to their TVL. These represent gaps in market coverage where a new pool would face genuine demand and limited direct competition.