Why is liquidity important?

Liquidity is important because all of crypto runs on liquidity just like the world runs on fossil fuel energies. Protocols and platforms that have high liquidity depth will be able to support more efficient trades. Over time this creates a monopolistic moat vs other protocols and platforms similar to how corporations like Google and Microsoft print money at will.

Liquidity mining has proven to be the go to method for DeFi startups to bootstrap liquidity. This was initially used to great success to attract liquidity to protocols. However this is a costly endeavor and it has been found that the yield farmers, who are the primary liquidity providers, are economically incentivized to sell often to lock in yields. This increases sell pressure, erodes treasury buying power, and decreases the token value for long term holders of the protocol.

Capital efficiency is a key metric for treasuries because they spend millions of dollars a week in incentives to source liquidity for their projects. The liquidity as a service (LaaS) industry is quickly catching steam, attracting $5B USD TVL in less than a quarter by offering greater liquidity depth and a higher capital efficiency. This nascent sector is being shaped by protocols such as Curve Bribes,  Olympus Pro, Tokemak, and UMA.

Curve Bribes  - Liquidity Direction

A protocol can participate in Curve bribes to increase liquidity depth. When a protocol engages in a curve bribe, they are bribing to control larger voting power, which is used to direct liquidity to a desired Curve pool. Abracadabra utilized bribes to great success, creating over $700m total liquidity for the protocol’s decentralized coin MIM. Curve Bribes on the MIM pool on CRV receive higher yields via increased liquidity rewards (SPELL + CRV incentives) as a result of the bribe. Currently ~14m/month (130M $SPELL @ .028) are allocated to Curve Bribes and towards Curve’s new votium system. For ~14m/month, Abracadabra gets significantly increased liquidity depth.

Olympus Pro - Bond Marketplace

Olympus Pro allows protocols to create a marketplace in which liquidity providers can trade their LP tokens in exchange for tokens held in the protocol’s treasury such as governance tokens or other tokens in the treasury. This marketplace allows protocols to buy back their liquidity and eventually own all of it, thereby being able to provide liquidity without paying large amounts to incentivize the liquidity pools. The marketplace uses a bonding mechanism to create a more efficient marketplace by automated price discovery.

Not only does this increase treasury diversification by owning LP tokens, the cost for liquidity also decreases,  which is often one of the highest recurring treasury expenditures. For example Alchemix emits about 16,000 ALCX/week (~30m USD/month @ ALCX = $475) to incentivize liquidity pools. One potential downside to Olympus Pro is that it requires a high upfront cost to begin buying back liquidity. Funds are usually raised by selling governance tokens at a discount in replacement of a yield to liquidity providers.

Since the initial launch of Olympus Pro in October, OP bonds have captured $7.5m of liquidity for our first seven partners — Abracadabra, Alchemix, Float Protocol, Frax, Pendle, ShapeShift, and StakeDAO. Olympus DAO TVL has grown from $150m TVL in September 2021 to nearly $4b USD (end of October 2021 at time of writing).

Tokemak - Decentralized Market Maker

Tokemark offers decentralized market making to any other protocol, thereby creating sustainable liquidity and more capital efficient markets. The Tokemak team was originally spun off from a professional DeFi market making firm Fractal. Tokemark recently started the process of liquidity deployment and finished its first Collateralization of Reactors Event (C.o.R.E) with C.o.R.E. 2 planned to start in early November 2021. As of the end of October 2021, in less than 2 months Tokemak’s TVL has surpassed $1b TVL and is set to launch its own version of directing liquidity via TOKE voting power in December 2021.

Liquidity provider rewards are paid in TOKE and the trading fees are accrued in the protocol. Over time these fees will hit a critical mass, the "singularity",  which will allow the protocol to self-sustain without the need for liquidity providers. TOKE holders can then direct this capital as they see fit, earning trading fees without paying out any more TOKE rewards, thus closing the liquidity cycle.

Success tokens - another treasury diversification option

Success tokens allow a DAO to offer investors call options on the governance token. Investors pay the full price of the token. This could be a possibly lucrative way to raise capital from investors like venture capitalists or even other treasuries so that both treasuries can diversify by swapping these call options. Who doesn’t want a call option on their favorite DeFi project?

Range Tokens are a capital efficient way to source liquidity

Range tokens by UMA allow DAOs to borrow funds without the risk of liquidation and simultaneously diversifies the treasury. Range tokens function like convertible debt. The advantage to raising funds using range tokens is that the governance tokens are sold later, presumably when governance tokens are valued higher than when the funds were initially raised thus increasing capital efficiency of the governance tokens. Governance tokens can be used to open a risk free collateral debt position with range tokens and use the funds raised to fund treasury purchases/expenditures such as buying liquidity with Olympus Pro Bonds or Tokemak.

UMA used a range token pilot program to raise $2.6m in funding from investors. The range token had a three month duration with a 25% APY yield and a price range of UMA being between $4 and $12. If UMA is greater than $12 at expiry, the investor earns an effective APY higher than 25% because the investor has long exposure to a $12 call option. If UMA is less than $4, the investor earns an effective APY lower than 25%, but the investor has short exposure to a $4 put option. Distribution was completed 1:1 between UMA and investors for speed and simplicity, but has flexibility to be distributed in the best way that suits the treasury’s needs.

KPI Options can incentivize treasuries to source liquidity more efficiently

KPI options are financial derivative contracts made by UMA which allow a protocol to incentivize progress towards a specific KPI (key performance indicator) goal and pay out increasing rewards based on how well the KPI metric was hit. KPI options offer an alternative to liquidity incentives and attempts to align liquidity provider incentives with the protocol incentives to prevent excessive selling pressure while increasing liquidity depth with the promise of paying out more rewards the greater the liquidity depth achieved is.

Although the current approach incentivizes higher liquidity depth, it is not capital efficient because the more successful the KPI options are and the more liquidity depth that is achieved, the greater the cost of treasury expenditure will be. Rather, KPI options should incentivize the adoption of LaaS services such as Curve Bribes, Olympus Pro, and Tokemak. This would add another economic incentive to incentivize more sustainable liquidity sourcing treasury strategies.

Conclusion

LaaS is a fast growing crypto infrastructure industry with high demand because every protocol needs liquidity. Not all protocol’s are utilizing the most capital efficient ways towards sustainable liquidity sourcing as they rush to front-run the inevitable LaaS services backlog. As DeFi continues to grow, LaaS will continue to flourish and will create the DeFi industry legos necessary to support future DeFi sectors.