Fluid is an interesting, difficult-to-understand, and highly controversial DeFi protocol. As a "new" DeFi protocol launched in 2024, its peak TVL exceeded $2.6 billion, and it still has $1.785 billion in TVL.
With a trading volume of $16.591 billion over the past 30 days, Ethereum's mainnet trading volume accounts for 43.68% of Uniswap's total trading volume. This is a remarkable achievement.
Fluid combines lending with a DEX, accepting LPs (such as ETH/wBTC) as collateral, allowing LPs to still earn fees while providing collateral. Fluid calls this Smart Collateral.
Okay, it seems rather ordinary.
Image generated by Nano Banana Pro - Gemini AI based on the original text.
Smart Debt is a unique design feature of Fluid. Normally, in lending, users borrow money and pay interest.
In Fluid smart debt, users also borrow LP trading pairs.
That's right. If you want to borrow 1000 USDT, you will borrow 500 USDT + 500 USDC. The trading pair borrowed by the user will be automatically deposited into Fluid DEX as liquidity.
In other words, users can choose to withdraw the funds for other purposes, just like a regular loan, or they can choose to pledge LPs to borrow from LPs and then deposit them into the DEX to earn more transaction fees.
Essentially, smart debt encourages borrowers to leverage LPs within Fluid for revolving lending. This protocol increases liquidity, attracts more traders, and allows LPs to earn more transaction fees. This is precisely the flywheel that Fluid ultimately aims to build.
Therefore, if you have studied Fluid, you will see many articles describing Fluid as a "DEX-on-lending" protocol, and this is the reason.
The Fluid architecture is like a composite structure; you can think of it as a main road and auxiliary roads, a trunk and tributaries, a two-layer cake, or anything like that.
The core underlying component is the unified Liquidity Layer, a smart contract used to store the liquidity of all assets. It is responsible for managing all the money and handling deposits, withdrawals, loans, and repayments.
Above the liquidity layer are multiple sub-protocols and Vault. The sub-protocols have their own business logic, but they do not directly hold assets. Instead, they use the liquidity layer to manage the deposit and withdrawal of funds.
The various sub-protocols are interconnected through a liquidity layer. For example, assets deposited by a user through a lending sub-protocol can be lent out by other Vault sub-protocols;
Assets deposited through smart lending can be lent out by Vault and simultaneously provide trading liquidity for DEX sub-protocols.
Ordinary users only need to interact with the various sub-protocols to conduct deposit or loan operations, without having to directly access the liquidity layer.
Specific operating methods
Typical lending agreements:
Alice deposits: 100 ETH (single token) Bob lends out: 5000 USDC (single token)
Fluid method:
Usage 1: Ordinary Loans
Just like Aave and Compound, you deposit collateral and your wallet receives a loan, except that the loan is lent out by LPs, such as USDT + USC, and the loan can be used anywhere.
Use Case 2: Smart Debt
While both involve depositing collateral and lending to limited partners (LPs), the difference lies in the fact that the Fluid protocol directly injects this money into Fluid's DEX trading pool. Users earn transaction fees through debt, and the liquidity pool expands its liquidity through debt.
Then, users can revolve the loan. This means using LPs as collateral to borrow from other LPs, then collateralizing again to borrow more, and so on in a continuous cycle. The official documentation gives a theoretical maximum leverage of 39 times based on a 95% LTV (Loan-to-Value) calculation.
What are the trade-offs of Fluid?
Fluid attempts to unify lending and trading within a single liquidity layer. To achieve this unification, certain compromises must be made, and these compromises are precisely the root cause of additional losses suffered by limited partners (LPs) during volatile market conditions.
In Uniswap V3, when the market price exceeds the LP price range, users only temporarily lose to earn transaction fees, and their positions become 100% of a single asset (e.g., all converted to USDC). This is impermanent loss, and the loss may disappear once the price returns to its normal range.
Fluid rebalancing transforms "impermanent loss" into "permanent loss".
Fluid automatically adjusts the liquidity price range for certain Valuts in order to maintain high capital utilization or to maintain lending health (preventing liquidation).
For example,
Suppose the price of ETH drops from 3000 to 2800.
1) Uniswap V3 Manual LP: The LP price range is still 2900-3100. Therefore, you would currently hold 100% ETH. If you choose to remain inactive and the price returns to 3000, the LP will return to its initial state with no additional loss.
2) Fluid Automatic Rebalancing: In order to ensure active liquidity (or for risk control), the protocol will automatically perform "rebalancing" when it detects that the price has fallen below the range.
At the 2800 level, a portion of the LP's ETH must be sold and converted into USDC to regain liquidity in the new 2700-2900 range. The consequence is that this "sell" action is a real transaction, selling the tokens at a lower price.
If the ETH price subsequently rebounds quickly back to 3000, as mentioned before, Uniswap V3 user assets will remain unaffected, and the token pair allocation provided by LPs will return to its original state.
In order to recover the price, the Fluid protocol must rebalance when the price rises by buying back ETH with USDC.
However, because it was sold at a low price before, it is now being bought back at a high price. This is actually a case of "selling low and buying high," a type of operation that frequently occurs in volatile markets, and this type of loss is known as LVR (Loss-Versus-Rebalancing).
Why does Fluid need to be rebalanced?
Because LP trading pairs play a very important role in Fluid in order to connect lending and DEX using a unified liquidity layer, even the loans made through lending are trading pairs.
Therefore, Fluid had to introduce a concept – “Shares”.
In Uniswap V3, LPs are non-fungible, and withdrawals are made via NFTs. Your actions only affect yourself.
In order for liquidity to be usable by lending protocols (collateral and debt), Fluid must design its liquidity pools to be homogeneous. LPs do not hold specific "ETH in this price range," but rather "x% of the entire pool."
When the agreement triggers rebalancing and causes the aforementioned "buy low, sell high" attrition, the total net asset value of the entire pool decreases. Since LPs hold shares, the price of a share = total pool assets / total number of shares, and the share price will fall directly.
Therefore, unlike in Uniswap V3, LPs cannot choose "I will not participate in this adjustment and I will hold on to it"; in Fluid LPs, they are forced to participate in the rebalancing.
For another example,
Assume the price of ETH is 1000 USDC. Invest LP 1 ETH + 1000 USDC (total value $2000).
At this point, the price dropped, with ETH falling from 1000 to 800.
1. Uniswap V3 (Do not operate)
As prices fall, traders sell ETH, forcing LPs to buy it. This reduces USDC and increases ETH in the LP pool. Eventually, at the low of 800, the LP pool becomes 100% ETH (let's say approximately 2.2 ETH, with no USDC remaining).
The current LP holdings are worth 2.2 ETH, or 1760 USDT. Although they are at a paper loss, the LPs hold a large amount of ETH.
2. Fluid Forced Rebalancing
The same situation occurs. The price falls below the lower limit of the range set by Fluid. The protocol determines that the current range (900-1100) is invalid. In order for Vault to continue generating fees (or for lending health), the range must be moved to near the current price, such as 720-880.
The key issue is that establishing the new 720-880 range requires 50% ETH + 50% USDC. However, your current position is entirely in ETH. Therefore, a forced action is implemented: Fluid must sell half of your ETH at the 800 price level and convert it back to USDC.
Therefore, 1.1 ETH was sold for 880 USDC, which was then used to form a new LP with the remaining 1.1 ETH.
The current value is 1.1 ETH + 880 USDC = 1760. However, at this point, your ETH holdings have decreased from 2.2 to 1.1. In effect, Fluid forced you to "cut your losses" at this bottom.
At this point, the price rebounded, and the price of ETH rose from 800 back to 1000.
Uniswap V3 (Lie flat, no operation required)
As the price rebounded, the 2.2 ETH held were gradually bought up and converted back to USDC. The price returned to 1000, and the LP position reverted to 1 ETH + 1000 USDC (ignoring transaction fees).
Total value 2000 U, impermanent loss has disappeared.
Fluid Forced Rebalancing
Prices rebounded, and the new range of 720-880 became invalid again. It is necessary to rebalance and move the range back to 900-1100.
Currently, there are only 880 USDC and 1.1 ETH. If the price breaks through 880, the LPs will only have USDC, because the ETH has been bought. At this point, the LPs' positions are all in USDC, totaling 1760 USDC, which is the 880 USDC they initially held plus the amount they sold later.
The protocol rebalances when the ETH price reaches 1000, buying ETH with regular USDC to maintain a 50:50 ETH:USDC value.
At this point, the LP's position is 0.88 ETH and 880 USDC. The total value is 1760 USDC, a loss of 240 USDC compared to the initial total value of 2000 USDC.
Moreover, this 240 U is a permanent loss.
The subsequent Fluid DEX v2 upgrade addresses the pain point of permanent loss during rebalancing by transferring the wear and tear costs to arbitrageurs in a "smarter" way, thereby significantly reducing this permanent loss.
First, there is a dynamic fee mechanism. When prices fluctuate sharply, the transaction fee will increase accordingly to compensate for the rebalancing losses of LPs.
Secondly, a "buffer zone" is set up for the oracle; if it is just a brief insertion, no rebalancing will be performed.
Then, LPs are allowed to customize price ranges, with wider options available; rebalancing only occurs when prices exceed these ranges. Asymmetric LP positions are also permitted, meaning the token pair does not need to maintain a constant 50:50 ratio.
If that's the case, why does Fluid have a TVL of $1.785 billion and account for 43.68% of Uniswap's trading volume in the past 30 days?
Fluid masks or offsets permanent wear and tear through extreme capital efficiency and low-risk strategies for specific assets.
Wear and tear comes from frequent rebalancing caused by sharp price fluctuations. But what if, however, the prices between LP token pairs didn't fluctuate?
For stable pegged assets like USDC/USDT or ETH/wstETH, rebalancing wear is virtually zero. However, Fluid's mechanism allows for leverage of up to 39x on these assets.
Furthermore, the returns include both lending and DEX revenue.
Therefore, Fluid's focus is actually on stablecoins, ETH and its LST assets, and BTC-related liquid assets, as shown in the data below.
Source: https://dune.com/entropy_advisors/fluid-liquidity
Another point is that Fluid's liquidation mechanism differs from typical lending agreements, with liquidation penalties as low as 0.1%.
If a lending agreement like Aave needs to be liquidated, external MEV Bots can take the collateral at a discount to help with the liquidation.
This "discount" is the liquidation penalty, designed to prevent losses from margin calls. Aave's penalty is 5%.
A unified liquidity layer allows Fluid to eliminate the need for external clearing, instead completing clearing directly on its own DEX. The system automatically sells a portion of the collateral to repay the debt. Therefore, penalties can be as low as 0.1% plus slippage.
This is actually a favorable trade-off brought about by a unified liquidity layer, which also benefits high leverage.
Therefore, Fluid is very beneficial for revolving loans of stable asset LPs such as USDC/USDT or ETH/wstETH, and will also attract stablecoin investment whales and aggressive on-chain traders.
Can I buy $FLUID tokens?
To be honest, I'm not sure.
Currently, there is no necessary connection between protocol revenue and coin price, although the Instadapp community and team have repeatedly hinted at or discussed Fluid's revenue distribution issue.
However, the protocol revenue is not currently being distributed to token holders.
Summarize
Tradeoffs are an extremely important, even primary, consideration in blockchain project design. To achieve core features, certain necessary conditions must be met, and these conditions, in turn, constrain the project.
Fluid is a project with a prominent trade-off. It is believed that the project team designed it from the outset to build a unified liquidity layer, expanding liquidity through lending and DEX features. The stablecoin LP and ETH and its LPT token trading pairs are the best entry point for expanding liquidity through leveraged cyclical lending.
