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CryptoEconomic Research

DeFi 2.0: An Alternative Solution to Liquidity Mining

DeFi 2.0 removes the protocols reliance on subsidized liquidity to one that is controlled by the protocol. Instead of protocols watering down their token supply in exchange for fleeting deposits, a new idea called “protocol controlled liquidity” (PCV) aims to acquire their own liquidity from the market or rent it from other protocols.
by James ChungNovember 12, 2021
DeFi 20 Market Commentary

Decentralized finance (DeFi) has been around for several years but its most notable projects started to take off just last year. For example, Synthetix launched the first liquidity incentive program in July 2019 which became one of the key catalyst’s for DeFi Summer of 2020. DeFi Summer was the start of the DeFi revolution where total value locked in DeFi smart contracts rose sharply from a few hundred million dollars to more than US $20 billion in a matter of months. However, DeFi Summer did not come around this time due to “mercenaries” depleting value from their systems (we’ll get into this more soon). With that in mind, DeFi is still considered new territory and experimental when considering the long-term viability of some of these protocols. New concepts are emerging to tackle some of the biggest problems encountered today in DeFi and one of those problems involves liquidity mining; this is what DeFi 2.0 attempts to address.

What’s wrong with liquidity mining today?

Most protocols allocate a large proportion of their native tokens into liquidity mining incentives to bootstrap themselves and attract more users. However, this has shown to be short lived as “mercenaries” tend to shop around other protocols for better incentives once they run dry. This has caused an endless cycle of dumping and farming for the next attractive token. The sell pressure followed by the dumping further impacts the token price and jeopardizes the overall sustainability of the protocol. Therefore, subsidized bootstrapping may not always play out as intended.

What is DeFi 2.0 and how is it different from DeFi 1.0?

DeFi 2.0 removes the protocols reliance on subsidized liquidity to one that is controlled by the protocol. Instead of protocols watering down their token supply in exchange for fleeting deposits, a new idea called “protocol controlled liquidity” (PCV) aims to acquire their own liquidity from the market or rent it from other protocols. A good way to understand these concepts is to look at some examples.

What are some examples?

Olympus DAO is one of the first project to create an alternative to the liquidity mining model using a bonding mechanism. In addition to staking, users can trade different assets in exchange for the discounted native token (OHM). This is known as the bonding mechanism because the discount is paid out over 5 days. These assets can include the 1) LP token that represents liquidity added to DEX’s and 2) single assets such as DAI or FRAX. The purchase of the LP positions from the market allows the protocol to create their own liquidity. For example, the protocol owns over 99% of the OHM-DAI liquidity according to their stats page:

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In a nutshell:

  • The protocol sells OHM at discount and in return receive LP tokens
  • Protocol takes control of the LP tokens allowing it to own the underlying liquidity
  • Since the protocol owns LP tokens that often include OHM (e.g., OHM-DAI) they own their own liquidity

In addition, Olympus Pro was recently launched to allow other protocols to leverage the same bonding mechanism and provide liquidity as a service (Laas) to the broader DeFi ecosystem. Protocols that purchase their own liquidity would obtain revenue from trading fees but would also bear the risk of impermanent loss.

Tokemak is another example that provides an alternative to liquidity mining but different in that it functions as a decentralized market maker. In Tokemak, each asset has its own pool called the reactor where its native token (TOKE) is used for directing liquidity. TOKE holders or liquidity directors decide where the liquidity should flow once a liquidity provider supplies its token to a reactor. Protocols are rewarded in TOKE for seeding liquidity into its ecosystem and can also direct liquidity by staking their TOKE token. This alternative to liquidity mining incentivizes both liquidity providers and liquidity directors. Unlike Olympus Pro, where protocols that purchase their own liquidity obtain revenue from trading fees and bear the risk of impermanent loss, Tokemak controls the liquidity and retains the trading fees while also bearing impermanent loss. Therefore, liquidity providers are able to provide one-sided liquidity with no impermanent loss.

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These alternative approaches to liquidity mining are still very much experimental but a step forward in the right direction. A perpetual cycle of subsidizing users with liquidity mining rewards is certainly not sustainable for most new DeFi protocols that have not established a moat. Fortunately, protocols will now have an alternative solution to address the issues presented by liquidity mining today. If any of these approaches prove to be successful, some of the more established DeFi protocols may adopt these concepts and allow for a more sustainable DeFi ecosystem in the future. That said, it will be worth monitoring the adoption of the DeFi 2.0 movement. As of today, the following projects have hopped on board the DeFi 2.0 movement to acquire or rent out their liquidity.

Olympus Pro
Coherts: Abracadabra, Alchemix, Float Protocol, Frax, Pendle, ShapeShift, StakeDAO, Synapse, Thorstarter, PoolTogether, Inverse, BarnBridge, KeeperDAO, mStable, Gro, Bankless DAO, Angle Protocol, Everipedia

Reactors: Frax, Alchemix, Tracer, Sushiswap, Olympus, Shapeshift, Visor, Synthetix, Illuvium, APWine

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