From “DeFi Summer” to “DeFi 2.0” Liquidity Incentive Scheme Improvement


  • The first “currency Lego” of the DeFi ecosystem, such as LP tokens and decentralized stable coins, created conditions for the further development of DeFi.
  • DeFi 2.0 is a new term in the ecosystem. It mainly refers to the emerging protocol subset built on the original currency Lego to promote the current DeFi ecosystem, mainly in the form of liquidity supply and incentives.
  • With the addition of these new financial primitives, the entire DeFi economy is rapidly becoming more friendly, safe and accessible.


Decentralized finance, often referred to as DeFi, is one of the most influential and successful waves of blockchain-based innovation. Driven by secure oracle networks such as blockchain with built-in smart contract functions and Chainlink, DeFi refers to a wide range of decentralized applications that break the existing traditional financial services and release new financial elements.

Driven by its inherent de-authorization portfolio advantages and open source development culture, the DeFi protocol is constantly advancing and iterating a mature model based on financial protocols. The DeFi ecosystem is developing rapidly. In the past few months, the rise of DeFi projects focused on liquidity has brought a new round of DeFi innovation, namely DeFi 2.0.

DeFi 2.0 is an emerging term in the larger blockchain community. It mainly refers to a subset of the DeFi protocol. It builds on previous DeFi developments, such as income farming and lending. One of the main points worth noting in the DeFi 2.0 protocol is to overcome the liquidity limitations faced by many on-chain protocols with native tokens.

This article considers past innovations that have created conditions for the DeFi 2.0 movement, and introduces the liquidity problems that the DeFi 2.0 protocol attempts to solve, and then delves into the utility and new financial models introduced by the DeFi 2.0 ecosystem.

Early DeFi development

Early DeFi pioneers, such as Uniswap, Bancor, Aave, Compound, MakerDAO, etc., established a solid foundation for the developing DeFi economy and introduced many key and composable “currency Lego” to the ecosystem.

Uniswap and Bancor are the original decentralized automated market makers (AMMs), providing users with the ability to seamlessly exchange tokens without giving up dragging. Aave and Compound introduced decentralized lending to provide on-chain income for deposits and obtain working capital in a de-authorized manner. MakerDAO enables users of the ecosystem to hold decentralized stablecoins and conduct transactions, providing a hedge against the fluctuation of cryptocurrencies.

Through these agreements, users can obtain reliable exchanges, frictionless lending and stable linked currencies-these are the three core financial elements widely existing in traditional financial markets. However, the infrastructure behind these familiar DeFi-based services is completely different from centralized organizations in terms of transparency and user control. The various technical implementations behind these decentralized services are the cornerstone of DeFi innovation.

Tandem DeFi innovation

A core example of blockchain-specific DeFi innovation is the liquidity provider (LP) token in the Automated Market Maker (AMM) Decentralized Exchange (DEX) protocol. Although DEX effectively serves as an alternative to centralized order book exchanges, the most popular DEX uses an AMM model called Constant Product Automated Market Maker (CPAMM).

The decentralized liquidity pool in AMM is used to facilitate the exchange of tokens, in which individual liquidity providers usually provide equal amounts of each cryptocurrency to contribute to the liquidity pool of an exchange pair. In return, they will receive an LP token, which represents their share in the liquidity pool and the fees they receive from facilitating the exchange.

From "DeFi Summer" to "DeFi 2.0" Liquidity Incentive Scheme Improvement

LP tokens triggered a cascading flow of DeFi innovations because they were quickly adopted by other DeFi protocols in multiple ways. For example, lending protocols such as Aave and Compound have iterated the idea of ??giving users receipt tokens that represent basic deposits, which are now called aTokens and cTokens.

The de-licensing nature of AMM and LP tokens also empowers DeFi startup projects. They no longer need to go through the listing process of a centralized exchange to launch tokens. If there is sufficient liquidity, the newly launched tokens can be immediately traded on the DEX. However, if there is not enough liquidity, the token exchange function of DEX will become limited in utility. Due to the existence of slippage, users need to pay astronomical prices for large exchanges. This leads to one of the most prominent problems currently existing in DeFi: liquidity issues.

Liquidity issues

Since the early days of the DeFi economy, liquidity has been a source of frustration for many emerging DeFi projects. The entire ecosystem is guided by tokens, as a way for the team to adjust the incentives of participants, collect rewards from user fees, and become a part of the larger DeFi ecosystem. However, in order to provide users with a strong source of liquidity to trade their tokens on the AMM protocol, the DeFi team needs to obtain a large pool of funds.

Part of the answer to this question is found in the third-party liquidity provider of the AMM protocol, through which any independent person with sufficient funds can provide liquidity for a token pair so that the team can obtain it from others Sufficient liquidity, instead of providing liquidity by yourself. However, end users have little incentive to channel liquidity for new tokens, as this means exposing themselves to the short-term risk of loss in exchange for minimal fee income from exchange. They need a good economic reason to take this risk.

This leads to chicken and egg problems. If there is not enough liquidity, the slippage caused by swaps will make users unwilling to participate in the DeFi protocol ecosystem. If no users participate through token transactions, there will not be enough fees generated to incentivize third-party actors to pool their tokens and provide liquidity.

From "DeFi Summer" to "DeFi 2.0" Liquidity Incentive Scheme Improvement

Thus, another key DeFi innovation was born. Rewards based on LP tokens have become the main way for the new DeFi protocol to guide liquidity. This process is called income farming.

Income farming

The emergence of revenue farming (also known as liquidity mining) caused a surge in DeFi activities in the summer of 2020, and is called the “DeFi summer” by blockchain enthusiasts.

The idea behind income farming is simple. The user provides liquidity for an exchange pair on the AMM protocol. After receiving the LP token, the LP token is pledged to obtain compensation for the project’s native token. This implementation method solves the chicken and egg problem and provides a compelling economic reason for third-party liquidity providers to provide liquidity for tokens: that is, more revenue. In addition to generating greater accumulated costs in AMM swaps, under the incentive of deeper liquidity, they can obtain more benefits by staking and obtaining more project native tokens.

From "DeFi Summer" to "DeFi 2.0" Liquidity Incentive Scheme Improvement

With the introduction of revenue farming, new DeFi projects can guide sufficient liquidity to start and maintain operations, and reduce the slippage of users entering its ecosystem. This has led to an exponential increase in the number of DeFi agreements, which also confirms that income farming has lowered the barriers to entry for users and DeFi project founders.

Limitations of profit farming

Although very effective, due to the special restrictions of the long-term income farming plan, it cannot completely solve the liquidity problem by itself. Income farming has performed well in guiding initial liquidity, but it must be based on a long-term plan to ensure long-term, sustainable liquidity.

This is because income farming has an inherent characteristic, that is, supply dilution. The founding team allocates native tokens to liquidity providers and provides additional sources of income to incentivize liquidity providers to lock their liquidity in the AMM pool. However, as more tokens are allocated to third-party liquidity providers, an increasing proportion of the total token supply is given leased liquidity, and liquidity providers can remove their liquidity at any time , And sell the LP pledge rewards they earn. The DeFi team cannot be sure if the staking rewards dissipate, the liquidity providers will stay, and keeping the staking rewards at a high level for a long time will increasingly dilute the supply of native tokens.

As projects increasingly seek to expand to different cross-chain AMMs, and even AMM agreements on the same chain, various income farming measures need to be taken on different exchanges to establish a deep liquidity pool for each project . This exacerbates the above restrictions, because emerging DeFi projects must finely balance the supply expansion to many AMM agreements–but they often don’t have the manpower, means, or information to do so effectively.

Third-party liquidity providers must be adequately motivated to provide liquidity for higher-risk holdings. Since newly launched tokens tend to have higher volatility, the risk of impermanent loss increases, which offsets the transaction fees of the AMM agreement and the income of the income farming plan. This represents an inconsistent incentive structure for third-party liquidity providers, who do not have many options to manage the risks of providing liquidity and profit farming.

Income farming is an influential way to channel liquidity for DeFi projects, but it is not without long-term risks. For most DeFi projects, running revenue farming plans and guiding liquidity are necessary and healthy, but the project team must pay attention to their token supply and long-term strategy to avoid negative impacts.

DeFi 2.0 and the pursuit of sustainable liquidity

In terms of liquidity, DeFi 2.0 refers to some emerging DeFi projects that hope to completely solve common problems related to liquidity supply and incentives. They provide alternatives and supplements to the profit-based farming model, and provide a way for the project to maintain a long-term source of liquidity. However, how can a blockchain-based native token project maintain healthy liquidity and distribute it in an ideal way?

OlympusDAO and the liquidity owned by the agreement

In 2021, one solution that will rise in the DeFi community is the bond (bonding) model of OlympusDAO, which focuses on the liquidity (POL) owned by the agreement.

Through its bond (Bonding) model, OlympusDAO reversed the script of income farming. OlympusDAO did not rent liquidity by expanding supply, but used bonds to exchange LP tokens from third parties at discounted prices in exchange for the original tokens of the agreement. This provides advantages for the agreement and any projects that use it (for example, bonds as a service). Through bonds, the agreement can buy its own liquidity, eliminate the possibility of liquidity exit, and establish a lasting pool, and it can also generate income for the agreement.

From "DeFi Summer" to "DeFi 2.0" Liquidity Incentive Scheme Improvement

On the other hand, users are incentivized to exchange their LP tokens through bonds because the agreement provides discounts on tokens. For example, if the price of Token X is 500 USD and the discount is 10%, the user can bond 450 USD worth of LP tokens to obtain 500 USD Token X. The result is a net profit of $50, which depends on a short vesting schedule (usually about 5 days to a week) to prevent arbitrageurs from extracting value.

Another key aspect of liquidity-focused bonds is that bond prices are dynamically changing and can have a hard upper limit. This has an important purpose for the protocol, which is to allow it to control two levers: the speed of token exchange liquidity and the total amount of exchange liquidity.

As a way to control the expansion rate of the token supply of the protocol, if too many users buy bonds, the discount rate will drop or even become negative. The agreement can also determine its expected amount of liquidity through a hard cap, in which case bonds are no longer available, further controlling the expansion of supply based on precisely determined parameters.

Realigned incentives

This multi-faceted model helps to readjust the incentive mechanism between third-party liquidity providers and on-chain agreements. Compared with independent third-party liquidity providers, the agreement has more conditions to withstand impermanent losses. Although third-party liquidity providers face the opportunity cost of representing every other liquidity pool and revenue farming agreement in the market, the agreement has additional incentives to maintain liquidity because it helps ensure users who trade with its native token Exchanges at low prices, reducing the cost of entering their respective ecosystems.

Ultimately, OlympusDAO’s bond model allows the agreement to better mitigate the risk of low liquidity in a long-term, sustainable manner. Combined with income farming, the DeFi protocol now has more tools for them to use to carefully plan their growth stages, from initial liquidity to sustainable long-term growth.

Guide fluidity with Tokemak reactor

Another DeFi 2.0 project that focuses on liquidity is Tokemak, which is a DeFi protocol designed to optimize liquidity and liquidity flow. In short, Tokemak’s scale aims to promote liquidity through two different parties-the Tokemak protocol and liquidity providers (LPs), with the goal of effectively decentralizing liquidity through liquidity directors (LDs) sex.

The following is its mode of operation. Consider the content of the LP token. Liquidity providers are required to submit equal amounts of two currencies in a given exchange pair. As the weight shifts and prices change, it will cause impermanence losses. In order to solve this problem, the Tokemak protocol holds stablecoins and reserves of the first layer of assets as the basic pair of emerging tokens. This constitutes an aspect of the liquidity pair. For the Token X-ETH liquidity pool on Uniswap, the Tokemak reserve contributed ETH.

Then independent third-party liquidity providers and DeFi projects can be brought together to form the Token X party of liquidity. At this time, liquidity directors (LDs) became the focus. The liquidity director controls the flow of liquidity by staking Tokemak’s native tokens, using these two unilateral liquidity pools, and then directing the liquidity to the extensive AMM protocol.

From "DeFi Summer" to "DeFi 2.0" Liquidity Incentive Scheme Improvement

Balance liquidity flow and direction

The final result of this system is that the liquidity flowing through Tokemak is committed to meeting the goal of efficient and sustainable liquidity in the entire DeFi ecosystem.

The liquidity director moves liquidity according to the voting mechanism, and the liquidity provider obtains Tokemak’s native token for providing unilateral liquidity. The variable income earned by each party is balanced with the other party to achieve an optimized ratio between the liquidity director and the liquidity provider, and to ensure that the amount of liquidity provided has an optimal number of directors.

This can benefit emerging DeFi projects��especially those run by the DAO��as well as farmers and liquidity providers. On a basic level, Tokemak’s unilateral asset allocation allows DeFi projects to use only their native tokens to guide initial liquidity, without the need for stablecoins and the liquidity of first-tier assets. Tokemak reactors can also provide a collective decision-making liquidity structure for DAO-based projects, while providing alternative income options for third-party liquidity providers and farmers who have reduced impermanent losses.

Other DeFi 2.0 developments

Another subset of the DeFi 2.0 protocol is based on previous revenue generation mechanisms and assets to create new financial instruments.

A prime example of this is Alchemix, a self-repayable lending platform with a “no liquidation” design. The agreement lends representative tokens that are 1:1 linked to mortgage assets. For example, by issuing DAI stablecoins as collateral, users can borrow 50% of the amount as alDAI. Then, the relevant collateral is deposited into the income-generating agreement so that it will gradually increase.

Through the combination of tokens and income-generating collateral, Alchemix can provide a non-liquidation lending platform that enables users to consume and save at the same time. As the collateral continues to gain income, the loan principal continues to decrease.

Abracadabra, another DeFi 2.0 protocol, uses a similar mechanism, but its system is related to MakerDAO. Users can publish collateral with income and receive MIM stablecoins in exchange to maintain the risk of collateral, while gaining income and unlocking liquidity for users.

Without the early innovations that initially brought vitality to the decentralized economy–the AMM protocol, decentralized stablecoins, and oracles–there would be no liquid bonds, liquidity liquidity mechanisms, or yield-generating collateral. From the early stages of AMM LP tokens and decentralized stablecoins to today’s DeFi 2.0 protocol, every project is a valuable iteration of establishing a decentralized economy.

Currency Lego in DeFi

Money Lego is a useful metaphor when conceptualizing how the DeFi economy moves as a unit. Cutting-edge innovations and new technologies can be combined, and each piece is built on top of the other, leading to the creation of something larger than the sum of its parts.

DEX and LP tokens are one of the most prominent currency Lego in the blockchain industry. They have realized the large-scale on-chain exchange of tokens and made income farming possible. The initial wave of decentralized stablecoins laid the foundation for an updated stablecoin design and decentralized lending platform through an airtight over-collateralization process and risk mitigation. Chainlink’s off-chain data and computing services provide the underlying infrastructure required by countless DeFi applications to help realize these innovations.

These currency Lego cannot be considered alone, but should be considered as an interconnected ecosystem that supports, connects and emphasizes other components to create new possibilities. By combining Chainlink Price Feeds and AMM LP tokens, dynamic income farming becomes feasible. By integrating stablecoins into AMM, users gain the stability needed only for trading on decentralized exchanges.

With the launch of DeFi 2.0, a new generation of currency Lego is being built on the basis of its predecessor to make the decentralized financial environment more effective, friendly and useful to its participants. Currency Lego continues to pile up-every additional square brings new value and opportunities to the DeFi ecosystem.

Note: The original text comes from ChainLink and is compiled for the full text.

Posted by:CoinYuppie,Reprinted with attribution to:
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