Why does the project party want to provide liquidity for its native token?
Fundamentally, having the liquidity of tokens is important because it allows new investors to easily invest in projects and allows inactive investors to exit. Less liquidity will not destroy a strong project, and too much liquidity is just futile.
In this article, we will understand the complexity of the 2 pools and give some solutions to the liquidity of their native tokens.
We will introduce:
- Liquidity ceiling target + other mechanisms to improve 2 pools;
- Uneven liquidity pool to cater to long-term participants;
- Use the capital in the idle fiscal treasury as a guiding mechanism;
Wait, what exactly is Pool 2?
The so-called 2 pools refer to the liquidity pools with project native tokens. They rely on decentralized exchanges (DEX) to survive and artificially guide liquidity by rewarding liquidity providers (LP) tokens. Although these pools are currently receiving attention as the default strategy for realizing token liquidity, they are one of the most subtle and unintuitive mechanisms in DeFi and therefore require careful attention.
How to consider incentivizing the liquidity of native tokens
The reality is that DeFi is full of hired capital, which is something that the project needs to consider when setting up 2 pools of rewards. The project party may consider APY of Pool 2 as the main marketing strategy to attract participants’ attention to the agreement. This is not only lack of creativity, but also often has nothing to do with the agreement itself, and our research (see Appendix 1) shows how bad marketing tools 2 pools are, because the liquidity they attract is not sticky. Among the dozens of 2 pools we sampled, the liquidity of almost all pools dropped by more than 50% 30 days after the end of the incentive. This volatile liquidity shows that instead of focusing on the 2 pools and the liquidity of their tokens, the project party should focus on using 2 pools to meet basic needs: to facilitate investors in the best environment (Low slippage) Buy/sell project tokens.
To consider what this will look like, we must first understand the idea of LP.
For the LP, the 2 pool is very complicated, because the project pays the income to the LP, which must be realized from the native token, and the LP must also hold this token. This is a delicate balance, because LPs are basically shorting major price changes and only incentivize LPs when they expect the tokens to trade within a certain range. If they expect the price of the token to appreciate rapidly, it will become more profitable to stop providing liquidity and hold the token. Or, if LPs expect the token price to show a downward trend, they will also choose to withdraw from liquidity. If a token is relatively new, then price discovery may be extreme in both directions, which exacerbates the so-called impermanence loss. This risk of impermanence also makes it difficult for the long-term supporters of the project to inject capital into Pool 2, because they may suffer losses due to the provision of liquidity.
Nevertheless, the liquidity of native tokens plays an important role for the project and the community. It is worth the price paid by the project party because it can start a reflexive flywheel that brings more users and attention to the agreement. *However, it is worth noting that the liquidity of native tokens will not make or break an otherwise stable project. Even if there is no proper native token liquidity, projects with strong product market fit can succeed, while projects with poor product market fit will fail even if they have strong token liquidity. Therefore, just as traditional companies need strict budgets, projects should strive to find the right balance between using tokens to incentivize the core behavior of their products and incentivizing the liquidity of native tokens. For the 2 pool, the main challenge is to determine the correct cost and pay the correct amount of liquidity.
There are other ways to distribute tokens outside the 2 pools. For a comparison of these alternatives, see Appendix II.
A better way to incentivize the liquidity of native tokens
Despite the nuances, it is undeniable that for projects, the 2 pool is a useful way to use their tokens (the excess tokens they own) to increase the liquidity of the tokens.
If a project party decides that pool 2 is their best method, here are three suggestions:
- Run a short schedule (30-90 days) to allow reconfiguration and empirical testing;
- Try to reduce APY (<100%), unlock block rewards, and non-transferable tokens to ensure consistency with long-term participants;
- Cancel the liquidity ceiling target to prevent excessive payments for liquidity;
On point (1), the project team should conduct shorter back-to-back experiments instead of locking themselves in a multi-year plan. The shorter plan allows the project party to analyze the effectiveness of its 2-pool plan and provide the project with the option to re-allocate and re-evaluate its leverage/reward (see Appendix III for the potential 2-pool indicators to be measured). It also allows the community to play a role in determining the project’s token incentives. Interesting case studies worth studying include PancakeSwap, 1inch and CREAM.
On point (2), the project should include the function of focusing on long-term participants. In particular, the project team hopes to incentivize LPs who are accustomed to holding tokens, rather than pure income farmers who buy tokens purely because of high APY. By making it more difficult to realize benefits quickly, these strategies can force LPs to act as stakeholders rather than farmers who only pursue benefits. In addition to Aave’s 2 pools (which we will explore in the next section), another case study is Ribbon Finance, which experimented with withdrawal fees, non-transferable tokens, and capped TVL for its early liquidity pool.
We will discuss point (3) in the remainder of this section, the liquidity ceiling target, and start with why it is important to have a target.
If the project has no goals, they will get stuck trying to figure out whether they have enough liquidity and whether they should pay more. Finding the liquidity ceiling target comes down to finding the minimum acceptable transaction size for larger investors and ensuring that the pool has enough liquidity to support it within the acceptable slippage range (<2%). Generally, the increase in liquidity can support the re-rating (upward) of the protocol tokens because the trading volume is sufficient for funds and large investors to purchase in the secondary market. The removal of the liquidity cap target ensures that you provide sufficient token liquidity for large investors without having to pay more than required.
How to revoke the liquidity ceiling target
One framework for considering the liquidity ceiling target is to consider the depth of liquidity relative to market value. In the table below, we have categorized different types of projects based on market capitalization and estimated the percentage of total market capitalization that large investors would like to trade within the 2% slippage range.
- Determine the market value of the project;
- Take the lower limit of the nominal transaction size;
- Use this equation/spreadsheet to determine how much liquidity is needed to facilitate transaction sizes at different slippage levels;
Example: I am the founder of a low-to-medium market capitalization project with a market capitalization of US$50 million. At most, I hope to provide convenience for large investors with a 2% slippage trading agreement with a 0.1%-0.3% token, which is about a transaction size of US$50,000 to US$150,000.
The formula used in the spreadsheet indicates that a $5 million pool (50/50 weight) can facilitate transactions with a slippage of less than 2% and a scale of $50,000. This means that my pool does not need more than 5 million US dollars to facilitate large investors, and I need up to 2.5 million US dollars of own tokens and 2.5 million US dollars of USDC/ETH capital pool.
Note: This is designed for the traditional AMM pool. Uniswap V3 changes these numbers and requires participants to have more confidence in price changes.
However, having high token liquidity is not always beneficial, and although the liquidity cap target can be used as a guide to prevent excessive payment of token liquidity, it is not the goal. For early-stage projects, token liquidity is not as important as focusing on products and finding product market fit. Low-market value projects that pay too much attention to the liquidity of tokens may attract traders/speculators at the expense of long-term investors and stakeholders.
The power of the uneven pool
Among the previous 2 pools, Aave’s incentive token pool is the only liquidity pool that maintains long-term liquidity without high APY (<5%).
In this 80/20 AAVE/ETH Balancer smart pool, LP provides liquidity to earn AAVE and BAL transaction fees and rewards. The success of Aave provides us with a window to understand the advantages of uneven pools over traditional 50/50 liquidity pools.
The main advantage is: less impermanence loss in the uneven pool.
The reduced risk of impermanent loss means that LPs are more willing to provide liquidity for lower yields. From a cost point of view, this reduces the amount of incentives required by the agreement.
At the same time, token holders can put their funds into use, and if the token price rises, the uneven pool will limit their risk of impermanence. This leads to better consistency of incentives, as they can obtain transaction fees and rewards without losing most of their exposure to tokens.
Although the unevenly weighted pool is more friendly to LP, it needs to be weighed. The main disadvantage is that a higher TVL is required to achieve the same slippage environment. As shown in the figure below, in terms of slippage, a 50/50 liquidity pool is the most effective.
Source: Balancer Labs
In addition, as the project matures, the uneven pool will also affect the rise of tokens, because the pool needs more stablecoins/ETH (compared to the 50/50 pool) to increase the price. After the initial fundraising/allocation is completed and the project is mature, the project can consider adjusting to a 50/50 pool to allow for better slippage and more effective price discovery. In terms of platforms, Balancer is currently the only protocol that provides uneven pools, and Sushiswap plans to launch a forked version (Trident) in the next few months.
Utilize idle treasury to create mixed liquidity method
Existing projects that have raised funds or have healthy/diversified funds should consider using all or part of the initial liquidity of their financial library and converting part of it into ETH/USDC to provide double-sided liquidity. This has many benefits, including:
- Allow project parties to earn additional income from transaction fees;
- Allow better control of liquidity, not just affected by APR;
- If the token price drops, an automatic “repurchase” mechanism is created;
- Diversify the fiscal pool (combine other asset pairs, such as ETH/USDC);
One thing to note is that the project party will bear the risk of impermanent losses.
Here is an example of dHEDGE. The agreement started with a reward of about 10,000 DHT per week (approximately US$20,000 at the time), but soon switched to providing most of the liquidity with US$3.5 million (50/50 pool). By using their fiscal pool to pay for liquidity, they can reduce the dilution of governance tokens and use it to incentivize people to use their platform. In terms of revenue, dHEDGE charges $500-1,000 per day in transaction fees, and it has collected more than $45,000 in fees in the past 2.5 months.
Here are some out-of-the-box ways that the protocol can use 2 pools to implement a hybrid strategy:
- Use idle treasury to provide a liquidity target of 50-80%, and then use protocol tokens to incentivize additional liquidity when necessary;
- Use the financial library to provide liquidity and charge transaction fees to incentivize additional LPs;
- Use the idle long-term fiscal treasury to provide liquidity for the first 6 months to 1 year, while conducting short-term experiments on liquidity incentives;
Alternatively, the project party can simply cancel the liquidity ceiling target and use the idle fiscal treasury to provide liquidity without incentivizing any additional LPs.
There is no precise science to realize the liquidity of the protocol’s native tokens. However, the various methods we have discussed (such as liquidity cap targets, uneven (ie 80/20) pools, and financial library liquidity provision) can allow thoughtful founders and investors to solve the liquidity problem of native tokens. Although most of this guide is just the tip of the iceberg, we hope it can promote discussions around designing more sustainable and efficient token liquidity.
Thank you very much to the Mechanism team (Andrew, Ben, Marc, Daryl, Alec) for helping to refine these ideas and filter the data, and also to Tristan, Zaheer and Julian for their helpful feedback.
Nothing in this article constitutes investment advice.
Appendix I: Asset Pool Research
Nansen’s research analyzed all token transfers from 400 liquidity farms, and found that a large percentage of profit farmers (36.4%) would exit the pool within the first 5 days of entering the pool. Today, only 13% of the addresses continue to be LPs. .
Source: Nansen Research
Similarly, the above heat map allows us to intuitively understand the situation of these profitable farmers. Forget about the incentive plan for several years, most of the income farmers had evacuated the pond on the 75th day. In order to quantify this further, almost half of the income farmers who entered at the start (ie the farmers at the top of the information funnel) will leave within 24 hours, and then 70% of the income farmers will leave within 3 days. With the reduction and dilution of LP rewards, those participants who are attracted by the incentives will simply take their token rewards and transfer liquidity to another pool.
After analyzing the 2 pools of 12 projects, we also found that although most of the incentive pools have experienced short-term liquidity growth, most of the liquidity levels have dropped by more than 50% within 30 days after the incentives ceased. One example is Badger’s 2 pools launched during the peak of the bull market.
Here, the data shows that the attempt to guide the liquidity of the token pool (see the red area) in early December has largely failed, and the bullish sentiment promoted the liquidity of the pool. Starting in March, as rewards decrease, the liquidity of the fund pool decreases in proportion to the decrease in rewards, which indicates that they are attracting mercenary LPs, and these people will sell tokens as rewards decrease. The graph also highlights the reflexivity of these incentive pools, because as LP sells tokens, it will lower APR, causing more LPs to withdraw from the pool. We have seen similar patterns in the 2 pools of $DHT, $ALPHA, and $1INCH.
Appendix 2: Comparison of OTC, CEX and DEX
Some exchanges waived listing fees for projects with good growth trajectories
Appendix III: Examples of 2 Pool Indicators
- Total number of users;
- The number of LPs vs. the number of pledgers;
- Average LP duration, the number of hired traders (withdrawal in a short time);
- The number of LPs withdrawn due to dilution/reduction of APR;
- Customer acquisition cost (CAC) and long-term value (LTV)
- Percentage increase in total TVL;
- Percentage increase in pool liquidity;
- Pool liquidity after LM incentive;
- APR to liquidity ratio;
- Market value to liquidity ratio;
- What is the relationship between the time of entering the pool and the time of the LP (notice length);
- What is the relationship between LP size and length LP? (Notify TVL/Address upper limit)
- Which are the common observations of long-term LPs rather than more observations of hiring LPs?
- Website traffic and user traffic (website clicks, time on page)
- Community activities/initiatives/proposals (side projects, discordant activities)
- New interactions on social media (number of tweets, new followers, tags)
Note: The original text is from mechanism.capital, and the author is Eva Wu.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/the-art-and-science-of-native-token-liquidity/
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