Institution: Mint Ventures
Author: Alex Xu, Research Partner, Mint Ventures
This article is part of Mint Ventures’ Mint Clips series. Mint Clips are some of our thoughts on industry events after internal and external exchanges. Compared with our#depthresearchreportand#trackscanningseries of articles, Mint Clips does not discuss specific projects, but mainly presents "staged insights" on specific issues.
introduction
The content of this article comes from an online discussion in the Mint Ventures group. At that time, I raised two questions. Our researcher Lawrence and investment manager Scarlett gave their own ideas. Combined with my thinking and extension of the issue, it constituted The main content of this Clip.
The two questions I raise are:
1. Should the token incentives of trading platforms be based on liquidity or trading volume? Why?
2. Assuming that the platform has a trading incentive mechanism, which is more beneficial or harmful to the protocol in order to obtain incentives, wash trading? Why?
*It should be noted that the "trading platform" in the above two questions is a general term, including spot Dexs (Uniswap, Curve), decentralized derivatives projects (Gmx, Gains), NFT trading platforms such as Blur, and even centralized exchanges (although most of them currently do not have direct liquidity or transaction mining mechanisms).
The following article represents the author and his team’s interim views at the time of publication. It may contain factual and opinion errors and biases and is for discussion purposes only.
Origin: Why do trading platforms issue equity tokens and provide incentives?
In my opinion, there are three main reasons why trading platform projects (including spot, NFT, and derivatives) need to issue equity tokens:
1. Token fundraising. This is easy to understand and I won’t elaborate on it.
2. Decentralized governance. The emergence and distribution of equity tokens is a prerequisite for community governance.
3. Means of regulating growth and economic systems.
However, from the perspective of Web3's business practices, options 1 and 2 are not mandatory because:
1. The project can be equity financed.
2. Centralized governance is still the mainstream of enterprise and project operations. Even for most projects that have begun decentralized governance, the governance content and voting are actually concentrated in the hands of the team and related institutions.
Perhaps the third point is what is really important: once a project has tokens, its incentive resources for growth and the regulatory capabilities of the project's economic system are greatly improved compared to projects without tokens.
The core purposes of token incentives for trading platform projects (whether it is to incentivize liquidity or to incentivize trading behavior) are generally only two, namely:
1. The new project achieves a cold start and attracts the initial bilateral users for the product through token incentives (Uniswap also carried out token incentives in the early stages of the Dexs war).
2. Expand the bilateral market and expect to accelerate the expansion of cross-side network effects through token subsidies to form barriers to competing products.
The "two sides" mentioned here, for most trading platforms, refer to the liquidity provider side and the trader side. Since the two sides of the platform are interdependent and mutually beneficial, that is, if no one provides liquidity, then there is no way to trade; and no trading means no commission return, and no one will be willing to provide liquidity. On the contrary, the richer the liquidity (under the same product mechanism), the lower the transaction loss, the more willing traders are to trade here, and the more commissions there are. The more commissions there are, the more liquidity returns there are, and the more abundant the liquidity is.
This situation where "user growth on one side provides greater value to users on the other side" is a type of network effect, namely "cross-side network effect". Network effect is one of the most important moats for commercial projects.
This is especially true for new projects.
If Uniswap could achieve initial growth at the beginning due to the lack of competition (there is no consensus on the value of DeFi) and relying solely on the natural demand of early adopters and users, then in the current situation where the trading platform track is so crowded and product iterations are changing with each passing day, it is extremely difficult for a bilateral or multilateral trading platform to successfully cold start without providing incentives (or airdrop expectations).
Therefore, purpose 1 (cold start) is the prerequisite for 2 (cross-side network effect). The ultimate goal of 2 is to form a competitive advantage (monopoly position) as a basis for achieving and expanding profits (protocol revenue > token subsidy expenses).
Well, due to the existence of cross-side network effects, whether the trading platform incentivizes liquidity providers or traders, it seems that it can indirectly incentivize users on the other side. Does this mean that:
Incentivizing LP = Incentivizing Trader?
Practice: Liquidity Incentives VS Transaction Incentives Early Practice of Cexs
In fact, whether it is incentives for liquidity or incentives for trading, they have already existed before DeFi Summer. For example, most centralized exchanges have incentive plans for cooperative market makers, the purpose of which is to allow them to provide good trading depth on their own platforms and allow other traders to have a low slippage trading experience. This is similar to liquidity incentives, but most of these incentives are in the form of fee reductions and refunds, and most of them have nothing to do with the platform's own equity tokens.
The earliest testers of transaction incentives\mining were also centralized exchanges. Dragonex was the first to practice it in 2018 and launched a "transaction mining" mechanism that rewards platform tokens (DT) based on transaction volume and distributes transaction fees based on platform token dividends.
This mechanism was then further developed by Fcoin. After the launch of transaction mining, the business of these two exchanges has achieved rapid growth. Especially Fcoin, as a latecomer in the "Exchange Wars", its daily trading volume during its peak period was the sum of all other first-tier CEXs.
However, the glory of both Dragonex and Fcoin did not last long. The former closed down due to theft of funds and debts, and the latter closed down due to the so-called "internal financial errors". The reasons for the collapse of the two platforms are slightly different, but the commonality is financial deficit. The former was due to external attacks, and the latter was due to internal problems.
But we can’t help but ask: If there had been no thefts and internal financial problems back then, could transaction mining have helped them maintain their market share in transaction volume and formed a barrier?
Later practice of DeFi project
The emergence of Uniswap has further pushed the AMM mechanism into the market. This mechanism has greatly lowered the threshold for liquidity market making and provided a natural convenience for the incentives of liquidity mining. Sushiswap quickly withdrew a large amount of liquidity from Uniswap through subsidies to LPs with its own tokens, causing Uniswap to launch a liquidity mining plan in a short period of time as a response.
In addition to Dexs, NFT trading platforms such as Looksrare, X2Y2 and Blur have also carried out a lot of practices on liquidity incentives, migrating the battlefield of subsidies from homogeneous tokens (FT) to the NFT field. It was also from Blur that Opensea felt a clear threat and began to practice 0 transaction fees to respond.
On the other hand, perhaps due to the tragic failure of Fcoin, the larger transaction mining practice in the DeFi field did not start until DyDx launched its tokens. Later practitioners included Cherry, a Dex project on Okchain, and Dinosauregg on BSC. Newer projects that include transaction incentives include level, gridex, kwenta, etc. But overall, there are still few projects that use transactions as the main incentive.
Liquidity Incentives vs. Transaction Incentives
As mentioned above, the purpose of token incentives by trading platforms is to take the lead in cross-border network effects more quickly and form a monopoly advantage. One of the prerequisites for monopoly is that [users are difficult or unwilling to leave the existing platform], and the relevant indicator in Internet product operations is [retention rate].
Therefore, whether the trading platform should incentivize liquidity or incentivize transactions, the important consideration is "which behavior or behavior object" is more likely to be retained for a long time after the incentive decays? Users and behaviors that are more likely to be retained for a long time can contribute higher "user lifetime value" (LTV) to the platform, and they should be the main incentive objects of the platform token.
So, who has more solidified behavior habits, liquidity providers or traders? Our current answer is liquidity providers, for the following reasons:
Compared with traders, LP users are more likely to be bound by the platform
For example, projects represented by Curve use the VE mechanism to guide LP users to increase their market-making income by staking CRV tokens, which increases the migration cost of LP and the consistency of interests with the platform.
LPs have more product migration intentions and concerns
The relationship between traders and platforms is one of instantaneous fund interaction. There is no fund custody to the protocol, so the fund risk is very small. However, the LP’s funds are authorized to the platform’s smart contract, which poses a greater risk. Therefore, they tend to choose platforms that they are familiar with, have a good security record, and have a long history to provide liquidity. There is a higher psychological risk in trying new platforms, and they are often unwilling to migrate even if the APR is higher.
With the existence of aggregators, trading behavior is more rational, with the lowest transaction loss as the only principle
Although there are aggregators that provide liquidity (depositing funds in machine gun pools or yield aggregators), because investing funds through an aggregator will have an additional risk of smart contract fund authorization, and aggregators often have a higher commission on profits (in comparison, trading aggregators often do not charge explicit fees), people tend to make markets directly themselves, especially with larger funds, there is almost no need to consider the gas friction caused by reinvesting profits.
The incentive for trading behavior is dissipated due to the existence of transaction friction
The frequency of trading activities is much higher than that of market making, and the friction generated in the transactions, such as GAS (including MEV) and NFT transaction royalties, are taken away by third parties other than the protocol and users, which is equivalent to the loss of part of the incentive.
Incentives to trade can “falsely increase demand for trading”
That is, there is the behavior of "trading for the purpose of obtaining incentives". This type of behavior seems to contribute to transaction fees and protocol revenue, but it may not be of much help to the purpose of incentivizing the project, that is, "realizing the advantages of cross-side network effects through token subsidies", because these "inflated trading behaviors" will disappear immediately after the incentive stops, and cannot help the protocol achieve the goal of "occupying a larger trading market share".
So in general, LP users have a closer and longer-term relationship with trading platforms than pure trading users. Incentives invested in LPs may bring back higher total user value in the long run. Perhaps it is precisely because of this that most trading platforms’ incentives are still mainly based on liquidity incentives, and there is relatively little exploration of trading incentives.
Outlook: How to better incentivize transactions?
Although in most cases, liquidity and trading are the only two incentives, and liquidity incentives are often the safer choice, the exploration of incentives for trading behavior is still of great value, because the ultimate profit of the trading platform still comes from trading, and the incentive for liquidity is also to provide traders with a better trading experience and obtain higher trading volume and transaction fees. When designing trading incentives, paying attention to the following points may achieve better results:
Instead of directly incentivizing trading behavior or volume, it incentivizes liquidity pools or trading pairs with larger trading volumes.
A typical example is the concept proposed by AC when designing the ve (3,3) project Solidly, that is, holders of ve governance tokens can only obtain transaction fees from the pools they vote for, rather than the entire protocol fees no matter which pool they vote for. This will guide ve token holders to vote more for those pools (trading pairs) with large trading volumes and more transaction fees contributed to the protocol, so that these pools can obtain more liquidity guidance (increase the token emission incentive for the pool), and thus have better depth, and further obtain more trading volume and fees, which is equivalent to "disguised incentive transactions". In addition to Solidly's Fork project, some other projects have also begun to try this incentive method. For example, Pendle has adopted the practice of "distributing 80% of the Pool's fees to ve users who vote for the Pool", which means that ve users will be more willing to vote for Pools with large trading volumes and increase token incentives for LPs.
Control the value of incentives to avoid "false increase" in transaction volume
As long as the incentive value of transaction subsidies is lower than the friction cost of transactions, people will not engage in inflated transactions "for the sake of incentives". Instead, when they have transaction needs, they will rationally choose platforms with transaction subsidies and conduct "transactions that they should take". In the long run, users may tend to trade more on platforms with incentives under similar conditions. When the behavior solidifies into a habit, the purpose of the subsidy is achieved.
Changing transaction subsidies from a “token distribution mechanism” to an “operational activity”
The token distribution mechanism is long-term and subject to prudent changes, while operational activities are short-term and flexible. Trading platforms can design short-term trading activities to activate key behaviors of new users (for example, defining the behavior of users completing their first transaction on the platform as "activation"), or design trading competitions and other activities for specific purposes to achieve short-term business goals (for example, to cooperate with financing and combat competitors). For example, Vela, a Gains imitation project on Arbitrum, uses a short-term trading incentive activity with a continuously adjusted reward mechanism and amount to attract users to migrate from Gains, Gmx and other platforms.
The above design direction for transaction incentives is also in line with the [retention rate] thinking mentioned by the author in the previous article, that is, focusing on real user behaviors that can bring long-term retention for more sophisticated incentive design.
Epilogue: In the low-barrier Web3 business world, operational efficiency is the key to long-term development
As Web3 business has developed so far, one of my important observations is that it seems more difficult to build a monopoly here. This is due to the Web3 world's own account system, permissionless capital flow and project creation, open source and transparent code, and composability. It is difficult to build a moat in this environment because it becomes more difficult to "enclose and monopolize" users.
If any project wants to survive and develop in this "low barrier" environment, it can only continue to compete for operational efficiency. Here, "operation" is a broad term, which includes many aspects of work such as product innovation, marketing activities, team management, etc., and accurate and efficient incentive design is also one of the important tasks. It is conceivable that the distribution and incentive model of tokens will inevitably need to be iterated more and more with the changes in competition and user needs, and become a long-term task. The "economic model that does not need to be changed" designed from a God's perspective may eventually be a delusion for most projects.
Therefore, as investors, when we select long-term investment targets, whether the project team has "long-term combat capability", "sustained business aggressiveness", and "willingness to actively respond to market changes" should be the key qualities we examine.
“Easy business victories” brought about by genius ideas will become increasingly rare in Web3.