Liquidity Incentivization

Fundamentals

DeFi removes centralized third-party intermediaries that control the flow of liquidity, such as banks and brokers, by utilizing a smart contract to manage rules for debt issuance and trading. However, this elimination of third-party intermediaries comes with a trade-off. To enable functionality, DeFi protocols must incentivize specific actors to participate and provide capital to the protocol.

During the rapid growth of DeFi starting mid 2020, liquidity was incentivized by providing governance token-based liquidity rewards. This approach enabled protocols to gain users by granting them a percentage ownership of the network, achieving the vision of fully user-owned decentralized protocols. However, as the number of protocols increased significantly, yield farming became more efficient, and users would quickly transfer mercenary capital between protocols. This resulted in protocols launching with billions of dollars in liquidity, only to see that quantum significantly decrease once token incentives became less appealing. The following paragraph will analyse these concepts.

Renting vs. leasing vs. buying liquidity

The concepts of renting, leasing, and buying liquidity are used in the context of providing liquidity to a financial market.

1. Renting Liquidity: This refers to incentivizing users to provide liquidity to a protocol, often through the issuance of reward or governance tokens acting as pseudo-equity in the protocol. This is similar to renting a car or a house, where the user pays a fee for temporary use of the asset. This approach is described as "renting" because users can remove their liquidity at any time. This can lead to instability as liquidity can rapidly migrate between protocols based on the most attractive incentives creating inefficiency in the system.

2. Leasing Liquidity: Some protocols have tried to slow down the outflows and to mitigate the instability of rented liquidity by incentivizing users to lock up their liquidity for a longer time frame for a higher reward. This is referred to as "leasing" liquidity. The longer the duration of liquidity provision, the higher the expected reward. This approach allows protocols to have a more stable source of liquidity over a given timeframe, increasing the stability and efficiency of the system.

3. Buying Liquidity: This refers to a protocol using its earned fees and governance tokens to provide liquidity on decentralized venues. Or, a user provides liquidity to the protocol in exchange for ownership of the asset. By buying liquidity, users commit to holding the asset for a longer period of time in exchange for potential future price increases, cash flows or a monetary premium.This approach is described as "buying" liquidity.

Thee concepts of renting, leasing, and buying liquidity help to illustrate the different ways in which users can provide liquidity to a financial market, and the trade-offs between short-term rewards and long-term stability and efficiency.

Analysis

A protocol should consider a combination of all three strategies - renting, leasing, and buying liquidity. However, the emphasis on each strategy would depend on the specific stage of the protocol's lifecycle, its financial resources, and its long-term goals.

1. Renting Liquidity

Renting liquidity is a strategy that can be particularly useful in the early stages of a protocol's lifecycle. By offering incentives such as reward or governance tokens, the protocol can quickly attract a large amount of liquidity. This can help the protocol to establish itself in the market and start generating transaction fees.

However, rented liquidity can be unstable, as liquidity providers (LPs) can easily move their funds to other protocols if they offer higher returns. Therefore, while renting liquidity can be a good strategy for getting started, it should not be the only strategy that a protocol relies on for its long-term sustainability as this creates a highly competitive environment where protocols must continuously adjust their bids to attract LPs.

From a game theory perspective, this can lead to a situation known as a "race to the bottom," where protocols continuously outbid each other, leading to potentially unsustainable reward rates. The Nash equilibrium in this game could be suboptimal for the protocols, as they may end up paying more for liquidity than they would like.

2. Leasing Liquidity

Leasing liquidity involves incentivizing LPs to lock up their funds for a certain period of time. This can provide the protocol with a more stable source of liquidity, as it reduces the risk of LPs quickly withdrawing their funds.

However, to attract LPs to lock up their funds, the protocol needs to offer attractive incentives. These incentives can be costly, and the protocol needs to ensure that the additional stability provided by leased liquidity is worth the cost.

Leasing can be a good strategy for a protocol that has established itself in the market and has a steady stream of transaction fees that it can use to incentivize LPs. It can also be a good strategy for protocols that operate in markets with high volatility, where the additional stability provided by leased liquidity can be particularly valuable. This changes the game from a dynamic auction to a more static one, where LPs must weigh the potential future rewards from other protocols against the guaranteed rewards from committing their liquidity - a form of repeated game, where the decision to commit liquidity affects not only the current payoffs but also the potential future payoffs.

3. Buying Liquidity

Buying liquidity involves the protocol using its own funds to provide liquidity. This can provide the protocol with the most stable source of liquidity, as it does not depend on the actions of LPs.

However, buying liquidity requires the protocol to have a significant amount of funds. Therefore, this strategy is typically only feasible for protocols that have been successful in attracting a large amount of rented and leased liquidity, and have been able to generate significant transaction fees.

Buying liquidity can be a good long-term strategy for a protocol that has established itself in the market and has a steady stream of income. It can provide the protocol with a stable source of liquidity and can reduce its dependence on LPs.

4. Summary

A protocol that is focused on sustainability and longevity should consider using a combination of renting, leasing, and buying liquidity. It should start by renting liquidity to establish itself in the market, then move on to leasing liquidity to increase stability, and finally consider buying liquidity as a long-term strategy once it has sufficient funds. This approach can provide the protocol with a balance of speed, stability, and independence, helping it to achieve its long-term goals.

Applying the concepts in DeFi

The correlation between the price of governance tokens and the amount of liquidity provided poses a challenge for DeFi protocols. In the event of a significant drop in the governance token price, the yield denominated in the token also decreases, leading to a potential exodus of liquidity from incentivized pools. In essence, protocols are merely renting liquidity from users, who have the freedom to withdraw their liquidity at will. In contrast, traditional capital markets utilize bonds and swaps rather than equity sales for liquidity payments. However, DeFi protocols only possess fees from platform usage and governance tokens held in their treasury, forcing them to often utilize governance tokens for protocol liquidity when fees do not suffice for network expansion.

In an effort to mitigate capital outflows from their platforms, Curve Finance pioneered liquidity provisioning protocols that incentivized long-term liquidity. This protocol offered higher interest rates to users who locked up their liquidity for extended periods of time. Curve Finance increased incentives by providing so-called boosts that offered higher token incentives for longer lock-up commitments. By incorporating duration constraints to prevent liquidity migration (investors leaving the protocol), Curve Finance introduced a novel design to liquidity incentivization. The vesting lock-ups and incentive boosts allowed the protocols to lease liquidity for a specified duration, instead of just renting.

During 2021, the notion of protocol-owned liquidity gained traction in the DeFi space. This concept involves a protocol utilizing its own accrued fees and governance tokens to act as a liquidity provider on various decentralized platforms. Fei was among the early protocols to adopt this strategy, utilizing create-redeem fees to provide liquidity to a Uniswap pool. Although this approach faced initial challenges, it paved the way for DeFi protocols to buy liquidity by leveraging their DAO treasury funds, with OlympusDAO being the first protocol to combine the three aspects of liquidity provisioning (buy, lease or rent).[1]

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[1] Chitra, Tarun, et al. "DeFi liquidity management via Optimal Control: Ohm as a case study." (2022). P. 3.