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Posted on Sep 07, 2022Read on Mirror.xyz

Can Crypto Liquidity Services Survive without its Business?

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https://dodotopia.notion.site/c74784af6bfe4981a579e92456231d57

Throughout history, every QE by the Fed will bring countless opportunities and result in high inflation. The total market value of the crypto market exceeded 3 trillion US dollars, yet now dropped to less than 1.4 trillion US dollars. The market again confirmed Arthur Hayes' point of view: crypto has primarily benefited from the Fed’s Quantitative Easing (QE) after the Covid-19 pandemic, yet, it is the most sensitive in reaction to Quantitative Tightening (QT).

For retailers, the actual liquidity of assets is way more important, especially in crypto. The collapse of Luna /UST and the accelerated flight of liquid assets caused by interest rates hike led the discussion on liquidity is getting louder and louder.

DeFi’s Need for Liquidity Incentives

Why does liquidity matter? Liquidity refers to an asset's ability to transform into another (i.e, a means of payment) without loss of value, and currency is the most liquid asset.

As the name suggests, all crypto-currencies rely on liquidity to operate. Protocols and platforms with deeper liquidity can run more efficient transactions; liquidity will be the most direct form of monopoly moat over time.

This is even more true in DeFi, where liquidity pools consisting of liquidity providers (LPs) directly drive markets.

Defillama data shows that the total value locked of DeFi protocols has dropped by 60% from ATH

Incentives play a more critical role in DeFi. The risk is an external variable for suitable protocols and cannot be controlled once the code is deployed. Consequently, protocols are forced to compete for the market’s liquidity on a rewards-only basis.

Liquidity mining has been a preferred method for DeFi startups to bootstrap liquidity, which was initially used to attract liquidity for the agreement with great success. However, it is costly. As the leading liquidity providers, farmers are financially motivated to dig and sell to lock in profits frequently. It increases selling pressure, weakens the purchasing power of the treasury, and reduces the value of tokens for long-term holders.

In addition, capital efficiency is a key indicator closely related to the project treasury, resulting in the rapid development of the Liquidity-as-a-Service (LaaS) track. It had attracted more than $5 billion in TVL in less than a quarter of Q3 2021 by providing better liquidity depth and greater capital efficiency.

However, as the TVL of DeFi protocols is plummeting, a question arises: how to maintain a healthy and stable liquidity level and manage liquidity has become the major problem for projects.

How to divide liquidity?

From the top-down approach, we can divide liquidity into currency liquidity, banking liquidity, and market liquidity according to the main body in the traditional financial market.

First, the value basis of liquidity is credit, and the most fundamental source and power that liquidity has come from credit. As of now, there is no individual or economic entity in the market that can provide enough credit to satisfy the liquidity of the entire market. Therefore, state sovereignty assumes this responsibility, and central banks reduce transaction costs when providing credit.

Second, a central bank regulates the market through commercial banks by adjusting its balance sheet to affect commercial banks’ balance sheets, then transmits it to the balance sheets of micro-subjects, such as individuals and enterprises, thereby impacting the entire macro market.

In Crypto, we may temporarily abstract the liquidity brought by credit and market operations as the "joint forces" from Satoshi Nakamoto and the Federal Reserve. Finally, market liquidity, independent of the banking system, mainly relies on various financial tools, technological innovation, etc. Market liquidity is not as continuous as others. It is homogeneous, mutated, and expected to change.

Obviously, the performance of the liquidity expansion brought about by QE is the hikes of TVL and prices at the data level. At the same time, the lack of states’ efficient macro-level regulations has caused DeFi protocols a sharply reduced liquidity.

So, if we start from the direction of innovation, do the liquidity services in the bear market have better liquidity and higher capital efficiency? Let’s dig our answer by analyzing the case from 3 points: supply relations, profitability, trade-offs and risk-reward.

Curve: bribes on stablecoin swaps

Curve War is a well-known topic. Here’s a pretty simple way to understand it: its core is the liquidity demand extended based on its stablecoin AMM; token bribes lead to more CRV emissions.

The secret of Curve's rise is centralized stablecoin issuances. The data shows that May 2021 is the time that Curve's TVL grew at a very high slope. It was also a period of rapid stablecoin issuances, such as USDC and USDT. Curve provided a huge liquidity supply as the core exchange place for stablecoins.

Also, the Curve team has cleverly designed the veToken mechanism from the very beginning. By enhancing the motivation of the organic demand for stablecoins, Yearn and Convex have been born, and Curve has successfully become a real primitive of liquid assets. The Curve War represents an improvement in capital efficiency, aligning its incentives with the project's long-term success.

Profitability:

The data shows that every $1,000 trading volume will generate $0.20 in revenue for Curve. It’s evident that Curve's revenue growth on the supply-side has gradually slowed down since 2022 but is still in a relatively healthy and profitable stage.

Risk and reward:

The main risk for Curve users lies in the dilution of governance power subjected to the mechanism. In addition, LP's extreme right has also become one of the unfavorable factors, and it has also facilitated competing protocols such as Solidly.

Curve's emission model suggests that the liquidity provider has three risk rewards: token emissions, fee revenue and sufficient exit liquidity.

Olympus Pro: bond and inverse bond markets

OlympusDAO played a central bank bond market role to pioneer PCV, a preferred stock similar to equity, subverting the reward cost of liquidity mining in a short time, and shifting to a more sustainable POL DeFi narrative (protocol as a service).

When the market was sufficiently liquid enough, OlympusDAO attracted liquidity by incentivizing users with high token rebase emissions, which was undoubtedly the root of its rapid growth and the source of its liquidity supply, yet the obstacle to its exit liquidity.

From the demand side, the APY for staking $OHM was over 10,000% in the first few months of the protocol’s launch, creating a positive loop for users in which people repeatedly bought and staked to get rewards. In addition, the launch of OHM Pro has provided $OHM with a large amount of arbitrage demand and become a solid foundation for its ecosystem expansion.

However, the data shows that $OHM price has fallen from nearly $1,500 in ATH to less than $20 today. The excess liquidity supply has caused $OHM to plummet so that most projects that purchase bonds through Olympus Pro lose money, forming a negative loop. In response, the team has launched inverse bonds to provide another exit method, thereby reducing the continued decay of secondary liquidity.

Profitability:

Thanks to the mechanism design of PCV, OlympusDAO's revenue sources mainly come from bond revenue, mining revenue, and transaction fee revenue of the treasury PCV. It also has a Runway of more than 500 days. Therefore, the profitability of OlympusDAO is still healthy.

Risk and reward:

With the withdrawal of liquidity, $OHM has fallen to its risk-free value, which means that the current liquidity value of the treasury is sufficient to fully support the exit of all circulating $OHM. In addition, the introduction of inverse bonds has added flexibility to take full advantage of PCV. However, when there is a liquidity crunch, $OHM does not have natural organic demand growth other than arbitrage at this time, and the risk-reward is extremely low.

Tokemak: renting liquidity

Different from Curve, Tokemak reconstructs the supply and demand relationship of retailers by introducing liquidity directors (LDs).

Suppose Olympus Pro is similar to a bond but works as a preferred stock (i.e., a growing PCV). In that case, Tokemak is closer to a traditional bond with a protocol that rents liquidity in exchange for trading fees.

Tokemak's business model is designed as a decentralized market maker, splitting the scarce resources controlled by traditional market makers: capital, knowledge and technology. Specifically, Tokemak acts as a technical component while capital and market expertise come from third parties, including LPs, LDs and price makers.

In simple terms, Token Reactors decide which assets to support, that is, which Token Reactors are available. LPs earn fees by funding Reactors, and LDs manage the funds in Reactors and make profits through market making. The vast amount of $TOKE emissions of the protocol serves the great incentives, ensuring that it operates as designed. All settlements are denominated in $TOKE, which underpins its value and acts as a stronger relationship in the protocol itself than other projects. The revenue is the actual revenue generated from the market-making behavior, which all goes to Tokemak, including transaction fees and other potential token incentives.Tokemak still has some defects. The protocol does not pay fees to LPs as tokens they invest in; instead, all fee is held and redistributed by LPs behind the protocol. Tokemak does not eliminate LPs’ impermanent loss but rather transfers such risk to LDs. LPs, therefore, only have a single asset exposure. In other words, it blurs the boundary between LPs and LDs.

From the demand side, the more $TOKE staked, the higher rate of return LPs have, attracting more LPs to deposit more. In addition, Tokemak has a bribery mechanism to drive demand. However, Tokemak's own business has no ongoing organic demand, so it has to continue to broaden its business scope to maximize its utility as a liquidity layer tool. Examples include partnering with many DEXs to become the dominant trading pair in this market, targeting DAOs to make capital diversification proposals, etc.

The data shows that the $TOKE price has dropped by over 90% in the past 3 months. A direct reason is that the team lacks confidence in the business logic: they have reduced the $TOKE rewards for a single equity pool, which made holding $TOKE less unattractive. Meanwhile, Tokemak canceled the mining rewards of $TOKE - $ETH LP on Uniswap, causing the trading pair, which previously had more than 100 million US dollars, to face huge selling pressure.

Profitability:

Token Terminal data shows that after the peak of protocol revenue in March, Tokemak's protocol revenue decreased to less than 5% of the peak with the negative spiral of TVL and $TOKE price.

Risk and reward:

Tokemak is a product with low capital efficiency. It builds on other products such as DEX, which has more of a liquidity symbiosis and synergy relationship. Therefore, users should exit decisively when liquidity crunches and teams are no longer confident in broadening their business and reducing emission rewards.

Ondo Finance x Fei Protocol: LaaS on structured products

Ondo Finance splits pools and LP assets into multiple investment classes by offering users a choice between token price downside protection and boosted returns: stable assets with fixed income or variable but higher APY volatile assets. Returns on current assets will be issued first and without impermanent losses; all remaining returns will go to contributors of volatile assets.

Unlike Tokemak, Ondo incentivizes LPs by establishing fixed income positions with lower risk and understandable exposure, while offering senior crypto investors new forms of leveraged exposure to take long-term positions.

Ondo Finance and Fei Protocol together launched a LaaS service specifically for protocols which is based on the structured vault. After depositing the project's native tokens into the Ondo liquidity vault within a specific time and pairing with FEI, this newly minted token pair is then sent to an AMM protocol, such as Uniswap, to provide liquidity.

Fei x Ondo, this design is attractive for projects that aim to generate on-demand liquidity without upfront costs to get liquidity on the other side. Fei Protocol charges a small fixed fee when the vault expires due to the provision of the other half of the liquidity position. As projects act as liquidity providers, they have the right to charge transaction fees and face potential impermanent losses. At the end of the term, Ondo will return the provided token liquidity after deducting transaction fees (positive numbers) and IL (negative numbers). This strategy offers the protocol a new way to provide liquidity at a meager cost in a short time.

Profitability:

Unknown.

Ondo announced before a 10M fundraise yet has not fully functional business and tokens; thus, we suggest its profitability is unknown. However, the data shows that Ondo currently owns about $100M TVL, of which more than 40% is FEI, 30% is FRAX, and the majority of the rest are long-tail assets.

Risk and reward:

Fei x Ondo's model is similar to commercial paper, a very short-term form of debt financing that usually charges slightly higher interests than bonds but provides borrowers with greater flexibility, essentially an intermediary and relationship between investment banks. Matching funding services is essentially the same as Tokemak's lack of organic demand. Currently, Ondo is mainly subject to smart contract risks since the tokens are not yet in circulation.

UMA: range tokens and KPI options are capital-efficient sources of liquidity

The oracle protocol UMA launched $Range tokens last year, which allows DAO to borrow funds without risk of liquidation while diversifying funds.

The function of the $Range token is similar to a convertible bond. The advantage of using $Range tokens to raise funds is that the governance tokens will be sold in the future, when the value of the governance tokens is presumably higher than the initial funds raised, thereby improving the capital efficiency of the governance tokens. Governance tokens can be used to open risk-free collateralized debt positions with $Range tokens and use the raised funds to fund treasury purchases/spending, such as using Olympus Pro Bonds or Tokemak to purchase liquidity.

In addition, UMA has introduced ¥Success Tokens: a way to raise funds for DAOs without offering token discounts upfront. Instead, the DAO provides investors with a call option to manage the token. Call options may bring more DAO token rewards to investors, but only if the token price rises, which also means that investors can only receive their own token rewards if the DAO performs well.

In addition to the $Success token, UMA has developed a financial derivative to track performance - KPI options, allowing the protocol to incentivize the progress of specific KPI goals and pay more rewards based on the completion of the indicators.

KPI options provide an alternative to liquidity incentives, combining LP incentives with protocol incentives to prevent excessive selling pressure and increase the depth of liquidity. However, since crypto is in a period of rapid expansion, the irreconcilable contradiction among LP, DAO and external investors has kept the actual organic demand for the KPI Option extremely low.

Profitability:

Unknown.

Risk and reward:

It uses a performance-linked approach, successfully incentivizing better liquidity depth, but capital efficiency remains low. Instead, KPI options should incentivize the adoption of LaaS services such as Curve War, Olympus Pro, and Tokemak. This move would add another economic incentive to encourage protocol strategies to incorporate more sustainable liquidity into the treasury.

UNI-V3 LP management: underrated organic demand

Most people may consider that LP management of Uniswap V3 is a falsified track, whether it is Visor Finance, which once flourished, or Arrakis Finance (ex Gelato Protocol), which is currently the largest LP. Indeed, the current V3 version has far less rewarding management strategies than V2 version, with V3 has infinitely magnified returns while magnified the risk to LPs.

Charm Alpha Vault: The darker light blue part is the base liquidity and the softer light blue part is the single-sided liquidity

However, repeated failures did not slow V3 adoption. On the contrary, users have become more dependent on the more flexible V3, which brought a huge amount of organic volume. The liquidity of V3 has become deeper and deeper. It also has more professional LP management, from the most straightforward use of backtesting scope to reducing impermanent losses or an active rebalance strategy to adjust positions, to execute Delta-neutral LP strategy by smart contracts now.

In addition, V3 gives LPs high leverage with small capital. LPs also need to face more challenges while high leverage amplifies earnings. The core of V3’s potential competitiveness is whether it can balance managing risks and bringing deeper liquidity and organic demand.

Profitability:

Unknown. The historical data shows that V3 LP management's overall return is unstable. Over a long time, the transaction fees of V3 have been closely related to the macro, and with Arrakis's current position ratio, nearly 25% of V3 LP's position, the income of V3 LP's management of this block (except for impermanent losses) is quite considerable.

Risk and reward:

At present, it is difficult for V3 management to have an objective maximizing profit point, and different strategies will lead to different results. Some strategies will focus on maximizing short-term fee income, while others will rely on the medium and long-term infinite grid to passively follow the maximization of income. In any case, the skills of controlling risks and losses will definitely win in the game of maximizing income.

Generate organic demand, LaaS development is still on the way

Today, many mechanisms and product business lines around liquidity exist, but transactions generate very few organic demands. Liquidity is precious in today's market, and how to provide better and more stable liquidity services will be the real challenge after the bubble fades.

Liquidity mining is no longer attractive in DeFi because of perpetual fees charged on the protocol balance sheet. Outnumbered DeFi protocols fragmented market liquidity, which shows a decline in the multiplier effect. Perhaps veToken or LD didn't induce liquidity that creates organic demand; rather, every transaction, itself, generates the liquidity demand.

Liquidity services derived from its market maker mechanism are more organic, as with Curve and Uniswap. In other words, the definition of LaaS is no longer limited to bootstrap; instead, it indicates the services based on liquidity and other derivative services to satisfy all Crypto users. As such, it has become commonplace for single-existing derivative protocols to have short lifespans and be less attractive.