The often overlooked investment opportunity that keeps the crypto markets humming.
What is returning more than private credit, but is better at preserving capital than private equity?...
…Don’t look now, but the answer is crypto (or at least, some types of crypto).
While traditional avenues like private credit and private equity are today considered the gold standard of private market investing, a new type of investment has quietly developed in the crypto market that combines strong annualized yields with near-perfect preservation of capital. The investment in question: liquidity pool (LP) investing, particularly stable-coin liquidity pools.
Although usually ignored by mainstream investors and financial managers because it has the word “Crypto” anywhere near it, stable-coin liquidity pool investing allows investors to extract value directly from crypto trading volumes without risking their original principal. While this type of investing may not yield returns as high as direct investment in a token that jumps in price (which often seems more art than science) and may not be as strong as private equity, with APY often in the low-teens, stable-coin liquidity pool investing can often outperform many private credit funds. Unlike private credit, it’s generally liquid.
In this article, we’ll dive into the mechanics of liquidity pool investing, explore how it generates returns, and examine why it stands as a formidable contender against traditional private market investments without succumbing to the usual exuberance of crypto investing.
What is Liquidity Pool Investing?
Liquidity pools are essentially crowdsourced pools of cryptocurrencies or tokens that facilitate trading by providing liquidity, much like a traditional market maker would in the centralized world. These funds are locked into an automated digital agreement known as a smart contract on a decentralized exchange (DEX), playing a crucial role in enabling efficient market operations within the crypto space without the need for traditional market makers. As a result, liquidity pools generate significant returns through fees and other incentives for the investors willing to provide that liquidity.
In the context of stable-coin liquidity pools, the assets involved are stable-coins: cryptocurrencies pegged to—and often collateralized with—stable real-world assets like the US dollar. This pegging significantly reduces the volatility typically associated with crypto assets, making them a medium for capital preservation in the digital asset space. By using these stablecoin assets in a liquidity pool investment, investors can generate the aforementioned fees without needing to take on the excessive risk associated with more typical crypto investments.
The Mechanics: How Liquidity Pool Investing Works
When investors contribute their assets to a liquidity pool, they effectively become liquidity providers. In return, they earn a portion of the transaction fees generated by trades made against the pool. Additionally, some platforms offer rewards in the form of their native tokens, which can then be converted to the initial investment currency, providing an extra layer of returns.
Here’s a simplified breakdown of the process:
Contribution: Investors deposit assets into one or both sides of a liquidity pool.
Facilitation: These assets are then used by traders on the DEX to swap between the two, paying fees for each transaction.
Earnings: Liquidity providers earn a share of these fees, proportional to their contribution to the pool.
This model ensures that liquidity providers earn consistent returns from the high trading volumes and fees without the risk exposure typical of speculating on asset prices directly.
Generating Returns: The LP Advantage
The primary allure of liquidity pool investing lies in its return-generating mechanism. Unlike traditional investments, where returns might be subject to market performance or company profitability, LP returns are derived from trading activity on the DEX. This provides a steady income stream that can be more predictable and less volatile, and importantly, isn’t tied to the financial performance of an underlying asset.
During periods of high trading volume, liquidity pool fees tend to increase. For instance, during the 2020 DeFi boom, platforms like Uniswap reported annualized returns for liquidity providers that far outstripped traditional investment yields. Even in more stable periods, the consistent trading activity on major DEXs ensures a reliable return. This is particularly advantageous because increased volume often begets increased volatility, but a liquidity provider only experiences the upside of the increased fees without the potential downside of a market correction.
Why Liquidity Pools Outshine Private Credit & Equity
Private equity and credit involve direct investments in private companies. Private equity aims for high returns through company growth or value extraction by leveraging the underlying company, with eventual exits. Private credit involves lending to private companies or individuals at relatively high interest rates with favorable terms to compensate for the associated risks. However, both private equity and credit are deeply tied to localized (often domestic) economies, making them vulnerable to economic shocks that can affect asset pricing or increase default rates, especially during downturns. Additionally, both are deeply illiquid assets.
Stable-coin liquidity pools, on the other hand, generate returns through transaction fees and trading incentives, independent of the equity of the underlying asset or the creditworthiness of the traders. These returns are generally less correlated with interest rate decisions made by the Federal Reserve or other central banks. This not only offers investors a more reliable income stream but also significantly reduces pricing risk, credit risk, and interest rate risk.
Moreover, liquidity pools are inherently more resilient to economic shocks. They rely on decentralized trading activity from around the world, allowing them to diversify away from the traditional domestic economies of individual countries. This cushions them against the financial health of specific companies in particular economies. By incorporating stable-coins, these pools offer an extra layer of principal protection, resulting in superior yields compared to private credit and often better capital safeguards than both private credit and equity.
The Medici Project: A Quick Case Study
At The Medici Project, we wanted to explore this unique investment opportunity and provide a “chain native” option that offers a fund model for investment while maintaining the deep transparency that the crypto trading industry is known for. We called it the Stable Income Fund.
To achieve this, we first had to develop methodologies for assessing the risk of particular assets, ensuring that the stable-coins we were investing with were indeed stable. We created a stringent asset rating system that evaluates volume, volatility, and pricing history, allowing us to selectively invest in high-quality stable-coin pools. This method ensures that our investors benefit from the stability and returns of the best liquidity pools available.
Additionally, we needed to address liquidity concerns. While investing directly in a liquidity pool is inherently liquid, private funds often are not. However, due to the liquid nature of the underlying assets, our team determined that allowing for near-direct withdrawals of the initial capital would be a workable solution. We are even planning enhancements to eventually automate this process, enabling the liquid nature of stable-coin investing to flow back to the investors in the fund without sacrificing the benefits of an actively managed and pooled fund model.
Conclusion: Embracing the Future of Investing
Liquidity pool investing represents a significant shift in the landscape of private market investments. By offering high returns and superior capital protection, it challenges the dominance of traditional avenues like private credit and private equity. As the world increasingly turns to digital assets and decentralized finance, the potential for stable-coin liquidity pools will only grow.
The advantages of liquidity pool investing are clear: it provides a steady income stream from transaction fees, reduces exposure to the financial health of individual companies or market fluctuations, and offers greater liquidity compared to traditional investments. This makes it an attractive option for investors looking to diversify their portfolios while mitigating risks associated with more volatile or illiquid assets.
At The Medici Project, we have embraced this innovative approach, creating a fund that leverages the stability and returns of high-quality stable-coin pools. Our stringent asset rating system and commitment to liquidity ensure that our investors benefit from both the security and profitability of this new investment frontier. By maintaining transparency and adopting advanced risk assessment methodologies, we offer a reliable and forward-thinking investment opportunity.
For investors seeking a blend of innovation, stability, and attractive returns, exploring liquidity pool investing is a wise move. The Medici Stable Income Fund stands ready to guide you through this new frontier, ensuring that your investment journey is as profitable and secure as possible. As we continue to adapt and grow in the ever-evolving landscape of digital finance, we invite you to join us in embracing the future of investing.
Investments in the Medici Stable Income Fund are offered under SEC Regulation D. This offering is only available to investors worldwide. All prospective investors from the United States must meet the SEC’s accreditation criteria to participate. Investing in cryptocurrency and liquidity pool funds involves risk, including the potential loss of principal. Past performance is not indicative of future results. Please consult with a financial advisor before making any investment decisions. This information does not constitute an offer to sell or a solicitation of an offer to buy any securities.
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