In-depth analysis of the liquidity loyalty problem that cannot be ignored in DeFi
Total value lock (TVL) is also the most popular and misunderstood indicator in DeFi. Total capital allocation (TCA) may be a more accurate wording. TVL implies that the value is “locked” in the agreement, loyal and unwavering. Unfortunately, for many projects, this is not the case. Short-term money games dominate. With the exception of a few blue chip stocks, all narratives guide prices. Narrative, price, and liquidity all have a highly reflective relationship.
In this article, we refer to liquidity as all liquidity related to the project-the liquidity of the governance token of the transaction pair, all relevant liquidity measurement standards in the agreement, etc.
In this article, we claim liquidity disloyalty by demonstrating the following:
Liquidity is sticky only in the highest quality projects. Even so, loyalty is fleeting compared to traditional stock markets.
The nature of unlocking early liquidity for everyone creates a huge risk premium. This is not inherently bad, it’s just different.
Early liquidity is not as loyal in design as later liquidity.
Token incentives that promote liquidity are a bandage solution that encourages network activity and liquidity. The attractiveness of governance depends on the value and reputation it governs.
We will accomplish this by providing a series of policy steps that the project can take to appropriately adjust incentives and attract more loyal liquidity providers and loyal token holders.
Act 1: Understanding the factors driving DeFi liquidity
As a high-level indicator, TVL can well demonstrate the overall interest in investing money in DeFi over time. From the DeFi summer (2020) to the second quarter of 2021, the growth of capital in DeFi has significantly exceeded the growth of Ethereum. Yields are easy to find, and liquidity is happy to stay on risky farms. Due to the popularity of Staking Pool 2, the project’s basic governance token has good liquidity. DeFi has experienced explosive growth, and TVL has significantly exceeded the growth of ETH’s market value.
Since then, cryptocurrencies have receded from the altcoin boom. As a result, the transition from risk-taking to risk-taking began, and the rate of return was compressed accordingly. Liquidity slowly flows out of the 2 pools and flows into stablecoins. If we take the Aave and Compound stablecoin pools as risk-free interest rates, due to the large amount of stablecoin liquidity but limited borrowing, the yield will be compressed to historical lows. The risk premium in the risk pool above these rates of return is also low.
During this period, the risk-return ratio was almost everywhere. In most cases, the price of tokens fell by more than 60%, resulting in a corresponding drop in yields, because the liquidity provider’s rewards were paid in the collapsed tokens.
The risk of impermanent loss (IL) drives many liquidity providers (LP) out of these pools, thus depleting liquidity and creating a natural seller. Over time, as prices continued to fall, more and more LPs surrendered. Despite the increased risk of IL, the price is in the gutter, as is the output of these farms.
As many of these LPs left Pool 2 to take risks, they found themselves looking for new sources of income in the stablecoin pool. Although DeFi is far from risk, the stablecoins that cross the space have reached historical levels. The demand for stablecoins is unwavering.
And many of these stablecoins are firmly on the chain, creating attractive stablecoin opportunities in DeFi, or are preparing to increase the trading volume of decentralized exchanges when cryptographic risks increase.
This shift to stable assets means that the liquidity of the risk pool has been basically exhausted. x*y=k Liquidity providers watch as impermanent losses swallow their profits. Take the buy and hold strategy of the popular governance token ALCX as an example. Keep the token from its local highest point at $1,800 to present a net return of -80%, which is about -70% if the unilateral bet of ALCX is taken into account. However, the liquidity provider in the ALCX-WETH pool caused a loss of -65% for LP, which resulted in a considerable return under higher risk and significantly higher management fees.
IL simulator: https://old.croco.finance/simulator
During this period, Curve, Aave, and Compound unsurprisingly dominated TVL because almost all of their liquidity was concentrated in stablecoins. But naturally, with the increase in liquidity, the aforementioned decline in interest rates also follows.
Curve and similar stable DEX can be said to be the only stable pool in the game with relatively low risks and attractive returns, so this kind of capital continues to remain abundant. The battle for Curve yield has become so fierce that Year, Convex, and Stake DAO continue to purchase and distribute a large number of Curve governance tokens, CRV, in order to fight for the best yield possible in the Curve meter. These meters are controls managed by the DAO and are used to control how rewards are distributed among the Curve pools. Lock CRV (veCRV) to vote on how these rewards will be distributed.
Data source: Dune Analytics
Curve may have created the most powerful incentive structure in DeFi, used to incentivize liquidity through governance tokens. Their use of CRVs in meters resulted in a large amount of supply allocated for production purposes, effectively locking up the vast majority of their token supply for a long time.
Data source: Dune Analytics
This creates a strong feedback loop where tokens retain value despite the continued and relentless selling pressure from relentless issuance/rewards. Countless parties continue to plant and dump these tokens on the open market. But as a top performer in the city, they can get away with it. Most other projects are not so lucky. Curve’s strong liquidity and first-mover advantage enable it to be continuously and strongly utilized in its stable capital pool.
Most governance tokens have not experienced the exact same fate. Like the anonymous tokens below, sparse use and thin liquidity tell a consistent story:
With liquidity almost exhausted, tokens now experience dramatic daily fluctuations in the presence of any signs of buyers or sellers. Since the aforementioned governance tokens are rewarded through liquidity incentives, continued selling pressure still exists. The project relies on governance tokens to incentivize use and maintain competitiveness. How long can the above agreement maintain the reward band-aid to remain competitive?
Act 2: For most “greedy” protocols, the current token design is an inevitable mid-term death spiral
For teams that do not have access to the stablecoin treasury, such access to their own governance tokens is problematic, especially if the team’s salary is paid in the project’s governance tokens. There is a potential feedback loop:
- Hiring farmers with limited loyalty, short-term locked-in venture capital, and team members who need to pay rent, continue to sell fresh tokens to the market.
- Prices have fallen correspondingly due to increasing selling pressure.
- The team must pay a large amount of tokens to keep the dollar equivalent salary unchanged.
- Farmers also see that their output is affected and choose to withdraw, let their positions be flooded, or increase capital to counter the impermanent losses and declining returns caused by the fall in token prices.
- As more and more tokens are sold to the public market, further issuances continue to drive down prices.
- Over time, liquidity will exit the pool because their positions are completely overwhelmed by impermanent losses or beginning to lose confidence.
- Retail investors and venture investors questioned their confidence in the project. Many people withdrew and pushed down prices further.
- Liquidity has gone through a death spiral, and the 2 pool of the project is now actually dead.
Due to the inherent risks and short-term loyalty of early projects, more and more teams are encouraged to spread their funds into riskier assets. This of course requires a trade-off. Mainly the community questioned the team’s beliefs about their project. Early in the project life cycle, it can diversify funding, and possibly the better.
If farmers and other stakeholders have the motivation to engage in mercenary behavior, what kind of motivation can guide the team, users, and investors to hold governance tokens and provide continuous liquidity? Many factors, but mainly:
- Current or future cash flow as rewards for expenses, token destruction, repurchase, etc.
- Marginal buyers push up token prices (prices are driven by narratives, usually narratives driven by cash flow-note the reflexivity in this relationship)
Governance as the only incentive for token holders is just an illusion. This is a weak attempt to evade supervision, delaying time on the real cash flow of the agreement.
Token holders expect more. They look forward to future liquidity. In traditional markets, we often observe liquidity premiums. Assets with superior liquidity are traded at a premium to improve investors’ cash-out ability. Encrypted assets are roughly the same. Projects without liquidity commitments will bring higher risks and lower loyalty-just like how TradFi market makers predict to avoid keeping too much risk on their books, retail and professional liquidity in DeFi Providers are also constantly monitoring risks. The generally poor liquidity in DeFi makes loyalty scarce.
Lack of liquidity and loyalty means avoiding risks at the first signs of danger. Evasion of risk marks a drop in the price of tokens. A drop in token prices signifies an exit from liquidity, and an exit from liquidity signifies a decline in the price of tokens.
Act 3: The new paradigm of early liquidity did not fail; it was just different
One of the hallmark innovations of the crypto revolution is the expanded access to early liquidity. In many ways, this is the democratization of venture capital. The old paradigm provides up to 10 years before retail investors can reach the company through initial public offerings, direct listings, etc. Now, traders and investors can obtain early liquidity, which can be said to be equivalent to pre-seed liquidity and seed stage, through ICO, IDO and early DEX liquidity.
It can be said that this early liquidity resulted in a huge price premium. Valuations in this area have been greatly exaggerated. It can be said that this is reasonable, because the inherent liquidity premium is provided to venture investors through public DEX liquidity at any stage. They no longer need to wait 10 years for an exit event. Many venture investors are salivating that even failed projects may still have a large number of opportunities to exit through retail. The winner receives more than 100 times the return. Even the worst loser may sometimes be a shuffle, a meager profit or a recoverable loss.
This creates a huge premium, and many venture capital firms compete for early allocation. Although the premium continues to expand, the valuation will exceed the level of the premium.
Early-stage capital was designed to have low liquidity. Venture capital involves lock-in and limited liquidity by design. The secondary market exists for exposure, but ultimately lock-in and long-term marriage between companies and investors is the status quo of traditional venture capital. Cryptocurrencies will soon realize that high-quality teams need investors to provide longer lock-up periods. The 6-month lock-in will not cut it at all. Venture investors can easily reduce losses and abandon the ship, selling their configuration to an open market at the moment their tokens are unlocked. They suffer from reputational risk, but short-term capital risk is still much more important.
However, the pendulum of this discourse may be too excessive in punishing venture investors for their behavior. In many ways, the new paradigm makes all retail investors become venture investors. The investment stage of the retail industry was historically reserved for venture capitalists. If we want to impose lock-in on venture companies, perhaps the team can explore expanding retail lock-in. The team that issues governance tokens in IDO and pledges Pool 2 DEX positions should explore the extension of the lock-up period of these governance tokens by 1-5 years and increase rewards.
After all, these projects and investors intend to appear in 1-5 years, right? The answer is often no. Teams and investors who prefer short-term incentives should expect higher risks and potential short-term returns.
It may be wise to manage long-term call options on tokens before selling a basket of products. Not because these projects may fail, but because the risk premium will be repriced in the next few years, because the project needs to provide more value for every project it sells.
Act 4: Adjusting incentives is a complex game that requires careful consideration of the desired outcome
Biology describes three symbiotic relationships in nature:
Mutual benefit: a win-win situation.
Symbiosis: One benefits while the other is unharmed.
Parasitic: One kind is beneficial while the other hurts.
In the initial stages of the project, almost all participants are participating in mutual benefit. When projects lead their networks, the earliest investors and liquidity providers take on higher risks. These early investors are usually outspoken supporters and assist in marketing, sometimes development work, analysis, etc.
Somewhere in the life cycle of these projects, this relationship becomes symbiosis, where marginal token holders no longer direct the network and now take less risk with expected returns. They tend to be less involved in the community. If they provide liquidity, then liquidity is usually less loyal. If they make a profit and run their impact on the project is trivial at best, their personal gains can be huge. If their positions are flushed out, the project will profit from their liquidity, but investors will suffer losses.
Finally, there is a third type of parasitic. They act purely to benefit their short-term results. They participate in mining-style governance practices. The results they seek will only benefit their personal results. They use dubious marketing strategies and rely on their influence to convince fringe investors. On the investor side, this may be a large allocation in a private round, but the lock-in time is short and the contribution to the project is small. In terms of projects, this may be a project that affects the community or has never reached a certain development milestone.
At present, many people in this field think that time is too short. But maybe this is okay. We are still in a cycle of rapid innovation. It is very profitable to think and surpass competitors in the short term. As more high-quality players enter the field, long-term thinking will become more profitable.
Liquidity is only as loyal as the underlying users of the project. As the project matures, these user categories will change. The current user behavior has changed a lot. There are good reasons. Innovative development is too fast, and liquidity cannot be combined with a team or code base. Perhaps over time, more moats will form and innovation will slow down. At present, concentration risk and extremism are foolish errands.
Act 5: Through wise policies, loyal mobility is possible, although it needs to be weighed
Through agreements and the right incentives and collective support of investors, the project can be prepared for success.
Before making some policy recommendations, what is the most reliable way to maintain liquidity? use.
If the basic product has no users, then token economics is not important.
Utilization rate-this is the Phuket people in cryptocurrency. In-depth study of utilization, many of these projects and networks are real “ghost cities”. They have active governance token pairs on DEX, but there is almost no reason to maintain this liquidity and loyalty.
Without utilization, the narrative is fragile. No use of cash flow is sparse.
With powerful utilization, the narrative is robust. With the use of cash flow is abundant. Our previous chart has changed…
Due to the above feedback loop, I think projects with long-term goals should wait longer to launch tokens or provide DEX liquidity. Pre-product projects either insist on seeking private capital commitments, lock in token transactions, or accept the risks/trade-offs of providing early liquidity to the community. Without taking advantage, prepare for a noisy journey. Please note that even most projects with functional products cannot attract a large number of users to grow and use its agreement.
So far, we will regard Sushiswap as the pinnacle of blue chip DeFi. Even Sushi’s user (address) reservation is difficult. Now imagine that it is not a peak blue chip project.
Data source: Dune Analytics
Despite endless incentives, innovation, top brands, and a completely strong community-driven strategy, Sushiswap’s user retention rate is still struggling.
Only a few projects showed strong utilization and cash flow. The irony is that among many of these incentives, these incentives are indeed the most fundamental, mainly because they can. Uniswap is an obvious example. There are no built-in liquidity incentives in Uniswap’s products. Base utilization drives costs, and these costs drive liquidity providers to continue to participate.
UNI token holders have not received any promises, although the general sentiment is an expectation of future cash flow and the value of the treasury.
Although many projects with Uniswap-v2 liquidity provide collateral, v3 has successfully attracted the liquidity and usage of the entire product, which is purely an advantage of using fees. Capital efficiency and product advantages are consolidating their position as the dominant player in the total amount of DEX.
Data source: Dune Analytics
In addition to the high liquidity of all currency pairs, the governance token itself also has high liquidity. The demand for Uniswap tokens is the highest in DeFi. Utilization is (almost) everything. Without it, any short-term reward is just a stopgap measure for long-term destiny.
Have your liquidity.
A unique method of loyal liquidity is to control liquidity in your project by owning liquidity. Let users buy and sell your tokens, but take steps to own a large part of your own liquidity. OlympusDAO is the perfect case study.
OlympusDAO provides a similar solution to the problem of loyal liquidity. DAO has more than 99% reserve currency liquidity. It does this by selling bonds to discount its tokens. The bond matures within 7 days. It sells bonds for Sushi Liquid Position (SLP) or stable currency. Over time, selling SLP bonds will increase DAO’s ownership of liquidity, and now owns more than 99% of SLPs in OHM-DAI and OHM-FRAX.
Data source: Dune Analytics
Selling bonds for stable currencies will increase the treasury. For OHM, this means acting as a backing for its reserve currency. For other projects that choose to sell bonds, this may mean that there are special funds to pay for developers, marketers, etc.
Over time, it is expected that more projects will adopt this autonomous liquidity structure, that is, they sell bonds in native tokens in order to have an increasing share of LP positions. The ownership of the project’s own liquidity also enables it to continuously collect fees from the pool. In this way, even if the tokens experience downward volatility, they can hedge by charging fees.
Codified loyalty. Accept the trade-offs of slower growth.
Several different methods of locking, attribution, etc. have been tried to achieve varying degrees of success in DeFi. main:
- Lock unilateral staking positions, liquidity position reward mechanism, long-term lock-up rewards, etc.
- The vesting period of the token rewards is to disperse the seller’s pressure/delay time.
- Reach a private agreement with investors and become a market maker for DEX’s LP and CEX.
- More extensive access to derivatives for LP positions. More flexible hedging means less need to exit positions.
The easiest way to mitigate the liquidity blow is to lock in. Although unilaterally locked staking positions will not directly incentivize liquidity, they will reduce the blow to capital allocators. Take CREAM as a good case study. Gradually increasing APY over a longer time frame will motivate stakeholders at all levels. Despite the thin liquidity, the selling pressure is still at a healthy level due to the stable and loyal liquidity of token holders.
The 4-year lock-up period promises the most tokens, and about 10% of the 3M token circulating supply during the 4-year lock-up period. The tokens locked in each other layer gradually decrease. Coin holders can get healthy rewards, and the agreement mitigates the blow by delaying time.
The expectation for a project is that within 4 years they have either figured out and experienced healthy growth, or almost failed. If they experience healthy growth, then liquidity will be strong; if they want, any large token holder will have a lot of liquidity to sell within 4 years. If they fail, then the liquidity discussion is meaningless anyway.
So far, the combination of healthy and sustained user/lender growth on CREAM and loyal capital has always been a successful combination of CREAM’s market value, but the liquidity of the project is weak, especially during the DeFi risk aversion period. Holders are more willing to pledge their tokens rather than take risky LP positions. The good news is that CEX liquidity is growing, and both FTX and Binance provide a healthy market for the CREAM/stable currency pair. However, the total liquidity of the project’s DEX and FDV is still very weak.
“How can I help you?” — Anonymous VC
A small number of venture capital companies in the encryption field are highly technical, and their technical niches are distributed in areas such as research, security/audit, and token economics. The vast majority of venture capital companies have low technology content and regard capital as their main value-added. Smart founders with large amounts of funds from new investors should explore formal agreements with investors to provide liquidity, preferably in basic pairs, but bootstrap utilization elsewhere can also indirectly promote the growth of the network. So as to be interested in the basic pair.
In a lending agreement, this may mean that the investor is the first to deposit in the lending market, using $500,000 to millions of dollars in stablecoins or the underlying token of the agreement to guide a pool to encourage others to follow. In DEX, this may mean adding capital to the strategic pair (which may be the token of the project). Founders should not be afraid to ask investors for their participation in these plans and lock in any returns from invested capital. Recently, more than one smart founding team rejected investors who could not promise to reward locked-in investors. Don’t be afraid to get more expectations from the earliest investors.
Finally, the use of open derivatives increases the flexibility and loyalty of LPs. Considering all factors, no matter what the result is, many LPs are more willing to follow this ship. Adjusting positions will create tax liabilities and increase complexity. Currently, most LPs are either restricted from accessing encrypted derivatives or do not have a product suitable for their required r/r profile.
Access to derivative products allows LPs to hedge their positions, leaving some returns in the upward scenario, and protecting capital in the downward scenario. Expanding access to derivatives will allow more LPs to stay in the game. For example, I may choose to continue rolling puts on the underlying securities in my LP position. Below we model the returns of various put options; obtaining more options for our underlying will be a positive step in the right direction and provide loans to more hedging liquidity providers.
Act 6: Closing Thoughts
Who knows that the future of finance will be driven by a group of talented engineers, nonconformists, and retail investors?
Either fast or rough.
The way forward.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/in-depth-analysis-of-the-liquidity-loyalty-problem-that-cannot-be-ignored-in-defi/
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