A High-Leverage Stablecoin Arbitrage Tool? Detailed Analysis of Fluid's 39x Leverage Strategy and the Dual Nature of Its "Low Liquidation Penalty"

Fluid is an interesting, hard-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 maintains a TVL of $1.785 billion.

The trading volume over the past 30 days reached $16.591 billion, accounting for 43.68% of Uniswap’s trading volume on the ETH mainnet. This is quite an impressive achievement.

Fluid combines lending with DEX, accepting LPs (such as ETH/wBTC) as collateral, allowing LPs to continue earning fees while being used as collateral. Fluid calls this Smart Collateral.

Well, that seems fairly standard.

Image generated by Nano Banana Pro - Gemini AI based on the original content

Smart Debt is Fluid’s unique design. Normally, in lending, users borrow funds and pay interest.

But with Fluid Smart Debt, users borrow LP pairs instead.

That’s right—if you want to borrow 1000 U, you will receive 500 USDT + 500 USDC. The borrowed LP pair is automatically deposited into Fluid’s DEX as liquidity.

This means users can choose to withdraw and use the borrowed funds elsewhere, as in traditional lending. Or, they can choose to collateralize LPs, borrow LPs, and deposit them into the DEX to earn more trading fees.

Essentially, Smart Debt encourages borrowers to use LP-to-LP recursive lending within Fluid, increasing protocol liquidity and attracting more traders, while LPs can earn more fee income. This is the ultimate flywheel Fluid aims to build.

So, if you’ve researched Fluid, you’ll see many articles describing Fluid as a “DEX-on-lending” protocol—this is why.

Fluid’s architecture is like a composite structure, which can be understood as the main road and side roads, trunk and tributaries, a double-layer cake—whatever analogy you like.

The most core underlying component is the unified liquidity layer (Liquidity Layer), a smart contract for storing all asset liquidity ), responsible for managing all funds, handling deposits, withdrawals, borrowing, and repayment.

Above the liquidity layer are multiple sub-protocols and Vaults. Each sub-protocol has its own business logic but does not directly hold assets; instead, it uses the liquidity layer to manage fund deposits and withdrawals.

Each sub-protocol interacts with others through the liquidity layer. For example, assets deposited via the lending sub-protocol can be borrowed by other Vault sub-protocols;

Assets deposited via Smart Lending can be borrowed by Vaults and simultaneously provide trading liquidity for the DEX sub-protocol.

Regular users only need to interact with the various sub-protocols to deposit or borrow, without directly dealing with the liquidity layer.

How does it work specifically?

Typical lending protocol:

Alice deposits: 100 ETH (single token) Bob borrows: 5000 USDC (single token)

Fluid approach:

Use case 1: Standard Lending

Just like Aave or Compound, deposit collateral and receive a loan in your wallet—the difference is that the loan is in LP form, e.g., USDT + USDC, which can be used anywhere.

Use case 2: Smart Debt (Smart Debt)

Similarly, deposit collateral and borrow LP. The difference is that the Fluid protocol directly injects these funds into Fluid’s DEX liquidity pool. Users earn fees from the debt, and the pool expands liquidity with the debt.

Then, users can loop borrow—using LPs as collateral to borrow more LPs, and repeat the process. According to the official docs, with a 95% LTV (Loan-to-Value), the theoretical maximum leverage is 39x.

What are the trade-offs with Fluid?

Fluid attempts to unify lending and trading in a single liquidity layer. To achieve this, certain compromises must be made, which are the root of extra losses for LPs in volatile markets.

In Uniswap V3, if the market price moves out of the LP’s set range, the user just temporarily stops earning fees, and the position becomes 100% one asset (e.g., all USDC)—this is impermanent loss, which may disappear if the price returns.

Fluid’s rebalancing mechanism turns “impermanent loss” into “permanent loss.”

Some Fluid Vaults, to maintain high capital efficiency or lending health (to avoid liquidation), will automatically adjust their liquidity price ranges.

For example,

Suppose ETH drops from 3000 to 2800.

1. Uniswap V3 manual LP: The LP’s price range is still 2900-3100. Now it holds 100% ETH. If the user does nothing and the price returns to 3000, their LP returns to the original state with no extra loss.

2. Fluid automatic rebalancing: The protocol, to ensure active liquidity (or for risk control), detects that the price has fallen out of range and auto-rebalances.

It must sell part of the LP’s ETH at 2800 for USDC to re-enter liquidity in a new range, say 2700-2900. This “sale” is a real trade—selling at a low price.

If ETH quickly rebounds to 3000, as above, Uniswap V3 LPs experience no loss—their token ratio returns to normal.

But Fluid must rebalance again as the price rises, using USDC to buy back ETH.

Since it was sold low and bought back high, this “buy high, sell low” pattern can happen frequently in volatile markets, leading to what’s called LVR (Loss-Versus-Rebalancing).

Why does Fluid need rebalancing?

Because to unify lending and DEX in one liquidity layer, LP pairs are critical in Fluid—even borrowed funds are in LP pairs.

So Fluid had to introduce the concept of “Shares.”

In Uniswap V3, LP positions are non-fungible and withdrawn as NFTs; your actions affect only your position.

But to allow the liquidity pool to be used for lending (as collateral and debt), Fluid had to make the pool fungible. LPs hold a percentage share of the whole pool, not a specific price-range position.

When the protocol triggers a rebalance and incurs “sell low, buy high” friction, the pool’s total Net Asset Value (NAV) drops; since LPs hold shares, share price = total asset value / total shares, so share price drops directly.

Therefore, unlike Uniswap V3, LPs can’t choose to “opt out” of adjustments; in Fluid, LPs are forced to participate in rebalancing.

Another example:

Suppose ETH is $1000. You deposit 1 ETH + 1000 USDC as LP (total value $2000).

Now price drops—ETH falls from 1000 to 800.

1. Uniswap V3 (Do nothing)

As price falls, traders sell ETH, LP absorbs ETH, so LP pool loses USDC and gains ETH. At 800, LP is now 100% ETH (about 2.2 ETH, no USDC left).

Current LP value: 2.2 ETH = $1760. There’s a paper loss, but you hold a lot more ETH.

2. Fluid Forced Rebalancing

Same scenario—price falls below Fluid’s set range. The protocol decides the current range (900-1100) is invalid and must move the range to the current price area, e.g., 720-880.

The key issue: a new 720-880 range needs 50% ETH + 50% USDC, but your position is all ETH. So Fluid must forcibly sell half your ETH at 800 for USDC.

You sell 1.1 ETH for 880 USDC, then recompose the LP with the remaining 1.1 ETH and 880 USDC.

Current value: 1.1 ETH + 880 USDC = $1760. But you now hold only 1.1 ETH (down from 2.2). In effect, Fluid forced you to “cut your losses” at the bottom.

Now, price rebounds—ETH goes back to 1000.

Uniswap V3 (Do nothing)

As price rises, the 2.2 ETH gets sold off, converting back to USDC. At 1000, LP returns to 1 ETH + 1000 USDC (ignoring fee income).

Total value $2000; impermanent loss disappears.

Fluid Forced Rebalancing

As price rises, the 720-880 range is invalid again; another rebalance moves the range back to 900-1100.

Now you have only 880 USDC and 1.1 ETH; as price breaks 880, all ETH is sold for USDC, leaving you with a total of 1760 USDC.

When ETH is back at 1000, another rebalance uses USDC to buy ETH, restoring the 50:50 ratio.

Now your LP is 0.88 ETH + 880 USDC, total $1760—a $240 permanent loss from the original $2000.

And this $240 is a permanent loss.

Subsequent Fluid DEX v2 upgrades aimed to address this permanent loss by shifting the “wear and tear” cost to arbitrageurs via a “smarter” mechanism, drastically reducing permanent loss.

First, there’s a dynamic fee mechanism: during high volatility, fees increase to compensate LPs for rebalancing losses.

Second, there’s an oracle “buffer zone,” so brief price spikes won’t trigger rebalancing.

Then, LPs can set custom price ranges and choose wider ranges, with rebalancing only occurring when the price goes outside. Asymmetric LP positions are allowed; the pair doesn’t have to stay 50:50 at all times.

Given all this, why does Fluid have $1.785 billion TVL and 43.68% of Uniswap’s 30-day trading volume?

Fluid uses extreme capital efficiency and low-risk strategies for certain assets to mask or offset permanent loss.

Wear and tear comes from frequent rebalancing in volatile pairs. But what if the LP pair’s price doesn’t fluctuate?

For stable-pegged assets like USDC/USDT or ETH/wstETH, rebalancing loss is almost zero. Fluid allows up to 39x leverage on these pairs.

Also, returns include both lending and DEX trading fees.

Therefore, Fluid’s focus is on stablecoins, ETH and its LST assets, and BTC-related liquidity assets. See the data below.

Source: https://dune.com/entropy_advisors/fluid-liquidity

Another point: Fluid’s liquidation mechanism differs from typical lending protocols, with liquidation penalties as low as 0.1%.

In Aave and similar protocols, when liquidation is needed, external MEV bots can buy collateral at a discount to help liquidate.

This “discount” is the liquidation penalty, designed to prevent protocol losses from bad debt. Aave’s penalty is 5%.

Because of the unified liquidity layer, Fluid doesn’t rely on external liquidators; it liquidates directly on its own DEX, automatically selling part of the collateral to repay debt. So the penalty can be as low as 0.1% plus trading slippage.

This is actually a beneficial trade-off from the unified liquidity layer, and it enables higher leverage.

So Fluid is very suitable for looped lending with stable-pegged LPs like USDC/USDT or ETH/wstETH, attracting stablecoin whales and aggressive on-chain traders.

$FLUID Is the token worth buying?

Honestly, not sure.

Currently, there is no direct link between protocol revenue and token price, even though the Instadapp community and team have repeatedly hinted at or discussed Fluid’s revenue distribution.

But for now, protocol revenue does not go to token holders.

Summary

Tradeoff is an extremely important, even primary, consideration in blockchain project design. To achieve core features, certain prerequisites are needed, which in turn constrain the project.

Fluid is a project with outstanding tradeoff characteristics. It seems clear that the team designed it to build a unified liquidity layer, expanding liquidity via lending and DEX features. Stablecoin LPs and ETH and their LPT pairs are the best entry points for using leverage and looped lending to expand liquidity.