Author: TapiocaDao
Time: 2022.10.20
Source: https://mirror.xyz/tapiocada0.eth/CYZVxI_zyislBjylOBXdE2nS-aP-ZxxE8SRgj_YLLZ0
Obituary of Liquidity Mining
June 16, 2020 - October 19, 2022
Liquidity mining is a mechanism that incentivizes users to provide liquidity and receive reward tokens. TapiocaDAO officially announced the end of liquidity mining today. We provide a novel and new DeFi monetary policy with characteristics such as sustainability, permanent value capture, and economic consistency among participants. The above characteristics are the "trilemma" encountered by the liquidity incentive mechanism, and TapiocaDAO solves this problem through DAO Stock Options (DSO). We invite you to read the following liquidity mining obituary and detailed information about this disruptive mechanism.
Liquidity mining began on June 16, 2020, and was launched by the decentralized lending protocol Compound. Participants will receive COMP tokens as rewards, whether they borrow or lend on the Compound protocol. These tokens are used to increase the return rate for borrowers and subsidize the interest rate for borrowers.
Compound’s “TVL” (total locked value) grew 600% immediately after the launch of the liquidity mining program. However, this had an unexpected adverse effect on Compound’s rapid growth. A small number of “miners” ended up holding the COMP tokens they received. According to the report, only 19% of accounts retained 1% of the COMP tokens they received, and 99% were sold on the market.
Secondly, the costs that Compound incurs for renting liquidity in the form of issuing & circulating new tokens often result in large operating losses compared to the revenue generated from renting liquidity. In this case, operating losses refer to the difference between the protocol's operating expenses (issued reward tokens) and revenues (fees). In addition to the severe dilution faced by COMP token holders, this large operating loss is its main negative impact.
As shown in the above figure, almost all DeFi projects are experiencing huge losses. This is not due to lack of revenue. DeFi protocols generate relatively high revenue. For example, AAVE's annualized revenue reached $101.4 million. The problem seems to stem from distributing 90% of its revenue to borrowers, leaving the protocol's profit margin at around 10% or $10.92 million, but this is not the core issue. The protocol itself still has millions of dollars in revenue. The problem lies entirely in the role of liquidity mining. AAVE paid $74 million in liquidity incentive fees, leaving the largest DeFi protocol with a net loss of $63.96 million. Does AAVE need to issue AAVE tokens to liquidity providers for free? No, but this is the reality.
However, the only profitable project is Maker. It has generated a total of $28.61 million in revenue, all of which belongs to the DAO. Without reward tokens and dividends, it proves that not every protocol needs tokens. In fact, many DeFi enthusiasts prefer protocols that do not provide tokens. No reward tokens, no operating losses, and no dilution. But it is undeniable that a well-designed and well-balanced token economic system can indeed work wonders.
Some may say, “These incentives attract liquidity, so what’s wrong with that?” “Liquidity is king.” What is actually attracted is not liquidity, but liquidity locusts; those non-loyal liquidity miners who take their rewards and leave to move to the next exciting token project or wait until the rewards of the current project are exhausted. Because these liquidity “locusts” use the single function provided by the liquidity mining token rewards - governance rights, Compound is now unable to even turn off the liquidity mining tap. This leads to a serious problem, that is, a gap between financially invested participants in a token economic system and loyal token holders. Loyal token holders actually contribute to the growth of the protocol, while liquidity miners want to get benefits at any cost. They will vote to continue to pursue the greatest benefit, and all this is our fault. We did not guide and design the token economic system correctly, which led to this imbalance. We should take responsibility for this problem and find solutions to restore the health of the token economic system.
Compound is not the originator of the concept of “liquidity mining” (not even smart contract-based liquidity mining). That honor should go to Synthetix’s “StakingRewards” contract, which was co-written by Anton from 1inch. Like many things, “liquidity mining” is just an old idea with a new name. In the crypto space, the concept of liquidity mining can be traced back to FCoin in 2018, a platform known for severely degrading the Ethereum network. In fact, FCoin was the first crypto product to offer something similar to the concept of liquidity mining as we know it, which they called “transaction fee mining” (a bit of a bad name, right?).
FCoin was founded by none other than Zhang Jian, the former CTO of Huobi. FCoin offered a large amount of token incentives to its traders, hoping that this liquidity would attract more users. FCoin actually bet that users would stay on the exchange after the liquidity incentive program ended. However, this was not the case. Users did not stay.
A token model with a good liquidity incentive design also needs a sound monetary policy, including solving token supply (dilution), token demand, token circulation, etc. This is crucial because it will affect the token price, which will affect the effectiveness of the incentive plan, which in turn will affect how much liquidity the protocol can attract.
The goal of current liquidity mining is to rent liquidity. Let's pose a question: Would you rather receive $1 million or $100,000? If you answered "of course $1 million", then you, like almost all DeFi protocols in existence, have not properly evaluated this question. How long will you have this $1 million? Taking time into account will reveal key details to correctly evaluate the true value provided. If the question becomes "Would you rather have $1 million for 1 second or $100,000 for 1 year", your answer will most likely be different. In one second, you can do almost nothing, but in a year, you can do a lot; the same is true for protocols.
These “liquidity rental incentive programs” attract liquidity speculators but are completely unsustainable and extremely limited in their core objectives. According to a study by Nansen, “up to 42% of liquidity mining participants exit within 24 hours of the program launch. By the third day, 70% of participants have withdrawn funds from the contract and have never returned.”
According to this data, liquidity speculators are only entering these projects to maximize their returns, and the protocols are not creating any real long-term value other than the negligible fee income, which is insignificant compared to the cost of incentivizing liquidity. In order to incentivize these liquidity mining participants, protocols usually allocate a large portion of the token supply to liquidity providers, because they have no loyalty to the protocol itself and only exist to extract profits. In other words, these token rewards are nothing more than protection money from the mafia, "as long as you keep paying me, your DefiLlama ranking will remain high, understand?" At the end of the day, what does the protocol actually own through liquidity mining? Nothing at all. Once the protocol stops paying rewards, liquidity will quickly disappear.
Whoever controls liquidity controls DeFi
Welcome to Olympus
Olympus revisited this broken model, and instead of trying to create a model that would pay for renting liquidity forever (which is obviously impossible), they correctly recognized that a protocol should create permanent value for itself and increase its balance sheet. They took advantage of the demand for OHM tokens and created POL (Protocol Owned Liquidity). They were the first to realize that instead of negotiating with liquidity providers, you could beat them at their own game and create permanent value for the DAO's balance sheet through gamification, making the mafia think they won.
While some may say that Olympus was a failed experiment, Olympus was the first project to introduce a continuous payment for renting liquidity. POL became an important mechanism in the "DeFi 2.0" space. So, Olympus was successful in identifying the key monetary policy omission in DeFi - the lack of real value creation, why did they ultimately "fail"? The 3,3 mechanism, like other liquidity mining projects, caused the OHM bubble to inflate by providing unreasonably high returns. (Remember: if you don't know where the income comes from, then you are the income).
Eventually, the economic inconsistency among the protocol participants reached a critical point, and the liquidity miners who controlled the majority of the OHM supply felt that they had extracted as much value as possible from it, so they withdrew, causing the OHM price to fall into a death spiral. Olympus panicked and offered a reverse bond. Reverse bonds allow users to sell their OHM tokens back into POL assets. This move resulted in the loss of OHM's POL (the only real value created), lacked diversity in the treasury reserve, and reduced investor confidence. Redacted became the only winning participant in Olympus because it quickly adjusted its strategy and maintained POL once the dilution was too high.
However, even if Olympus "failed", the significance of Olympus and POL should not be denied.
Entering the VE era
ve, or "voting trusteeship", was first introduced by Curve and is specifically embodied in veCRV. Curve places great emphasis on protocol loyalty and requires that liquidity rewards be locked up so that potential liquidity providers can get the maximum return rate from the liquidity incentive program. Curve actually creates a tiered incentive structure: the more loyal you are to Curve, the more rewards you will get.
While the approach of factoring in loyalty (now lent liquidity + time) greatly enhances Curve’s ability to keep economic participants aligned and create more loyal protocol users, the problem remains: Curve does not own liquidity; investors are still subject to dilution from token distribution, while liquidity providers can still earn valuable CRV at almost no cost (withdrawing provided liquidity at any time). Imagine how much value Curve could create with its POL if it wanted to, but that value was left on the table and captured by Tapioca.
When the value of CRV drops, the CRV incentive becomes less valuable, and therefore these token issuances become less valuable. Protocols fighting over veCRV in the Curve Wars created the mechanism of “incentive embedding”; protocol X mints and circulates their tokens through an incentive plan to own veCRV and thus control the incentives of CRV. This is a great mechanism, but as a protocol, all you’re doing is diluting shareholders by minting new tokens for an illiquid asset like veCRV. Add in Redacted and Convex, and you have a mechanism within a mechanism within a mechanism. These features should have been built into Curve from the beginning. ve’s inefficiencies literally spawned an entire industry. You might attract more liquidity through veCRV incentives than through your own token, why not focus on increasing the value of the incentives themselves?
This isn’t a criticism of Curve, as it’s clear that ve is the best staking method ever, as it aligns the economic interests of its participants. However, at the protocol level, the Curve war is a bit illusory. As a protocol, why give up valuable assets to acquire an asset that is less liquid and may not have valuable incentives at any given time? In fact, similar to Yearn, Badger, and StakeDAO, offering services to rent veCRV is actually more attractive - taking advantage of its intrinsic value while its value exists. Attract liquidity through "rented" veCRV and keep this liquidity trapped in the protocol as permanently as possible.
Finally, for Curve, the only way it can create perpetual liquidity is to become part of the “mafia”. Protocols need Curve to stabilize their stablecoins, not to earn fees. What if instead of trying to rent more liquidity, you directly own more liquidity with the fees generated by the Curve pool? This is exactly what Tapioca is doing. We have left the virtual world, taken the “red pill”, and tried to own the only real thing in DeFi - liquidity. Or you can choose to take the “blue pill” and pretend to incentivize liquidity in perpetuity by gamifying these mechanisms more. I will show you how deep the rabbit hole really goes, Neo.
Enter Andre Cronje
Before Andre founded Solidly Exchange and ve3,3 - two initiatives that attempted to solve the persistent problems in ve liquidity mining, Andre created OLM - Options Liquidity Mining for the experimental automated network Keep3r Network.
Andre (in his usual fashion) pioneered something that would later revolutionize DeFi. If you provide liquidity to Curve and receive CRV as your liquidity mining reward, what actually happens? The liquidity provider exercises a CRV call option with a strike price of $0 and no expiration date. When you start to think of the issuance of liquidity mining programs as American call options, the protocol suddenly has power that it didn't have before.
The problem with Andre’s OLM is that the protocol still doesn’t create any POL (protocol captured liquidity). The redemption of options is the key to DSO. oKP3R distributes option redemptions to vKP3R holders, which is a noble and simple way to incentivize lockup. But we are back to the core question again: “Why do we provide liquidity incentives to our protocol?” The purpose is to generate enough liquidity depth to maintain the core functions of the protocol, but the purpose of these services is to generate income to maintain the operation of the entire organization. By holding your own liquidity, you no longer need to provide incentives for it. Choose to accept the red optionization “red pill” and exit the matrix world of liquidity mining.
Turn off the printing press
Synthetix Improvement Proposal SIP-276, proposed by Kain Warwick, addresses the severe inflation issues that have emerged in DeFi protocols over the summer. These protocols heavily incentivize (renting) liquidity, and Synthetix hopes to (as usual) take the lead in preventing further expansion of supply. When Synthetix's revenue has even surpassed Ethereum at some points, it is hard to refute that it has successfully launched its ecosystem.
As Compound has seen, shutting down these rewards can be very difficult because liquidity providers often control governance. If the proposal passes, liquidity could leave the protocol immediately as rented liquidity, and fees would drop due to reduced liquidity depth, making it difficult to maintain the ecosystem in the future. Although Tapioca will follow a similar path, Tapioca will strive to acquire as much POL as possible during the expected inflation process. Once the supply reaches a predetermined peak, the protocol will be sustained by its own POL. The fees and earnings on these POLs will form a virtuous cycle (acquire POL > create earnings on POL > acquire more POL > repeat). Tapioca will be able to carefully inflate the supply of TAP to a predetermined level using American options, which themselves create perpetual value.