Written by: Paul Timofeev

Compiled by: TechFlow

In the DeFi space, liquidity is crucial.

Liquidity refers to the ease with which an asset can be converted into cash. The more liquid an asset is, the easier it is to cash it out, and vice versa.

In DeFi, liquidity is measured by price slippage, which is the difference between the expected price and the execution price when trading an asset on automated market makers (AMMs) like Uniswap. Better liquidity reduces price slippage, making trading more efficient and benefiting all participants. Therefore, in DeFi, projects have an incentive to create deep liquidity for their native tokens to accumulate value and attract more users.

However, many L1 and dApp total value locked (TVL) charts look similar — a rapid burst of liquidity and growth followed by a significant drop-off. DeFi has learned the hard way that acquiring and retaining liquidity over time is much more difficult than building liquidity in the short term.

As top market makers like Jane Street and Jump Trading reduce their involvement, the need to design sustainable token models becomes more important.

Liquidity comes...and liquidity goes.

Liquidity mining refers to a mechanism that incentivizes users to provide liquidity for a token through native token rewards. Pioneered by Compound and Synthetix, it has become a common mechanism for DeFi projects to drive growth.

But we will soon find that this approach is extremely unsustainable in the long term and a bad business model. Protocols continue to struggle because they need to generate enough revenue to cover the costs associated with emissions. Below are the profit margins of several DeFi blue chip protocols from January to July 2022.

Take Aave, which has the third largest DeFi TVL. Although they generated $10.92 million in protocol revenue, they also paid out nearly $75 million in token emissions, resulting in a loss of $63.96 million, or a -63.1% profit margin.

DeFi needs to move away from unsustainable designs that fail to maintain liquidity and adopt more attractive token models that encourage long-term participation and growth. Let’s examine some models that aim to optimize the current state of liquidity.

LP Gauge Tokenomics

Curve Finance launched the VoteEscrow model, allowing $CRV holders to lock their tokens to obtain $veCRV, granting holders governance rights and increasing returns.

While this model somewhat offsets short-term selling and encourages long-term participation, it also reduces $CRV liquidity as many tokens are locked up (even for up to 4 years).

Instead of locking up native tokens, some protocols have built models that focus on locking up LP tokens.

LP Gauge economics incentivizes LPs that provide liquidity to lock up their LP tokens in exchange for increased rewards and greater governance rights. In this model, traders benefit from the safety net of “locked” liquidity, LPs gain governance rights and greater rewards, and the ecosystem benefits from deeper liquidity.

One project that has adopted this model is Balancer, which launched the $veBAL token economics. Here, users who provide liquidity to the BAL/WETH pool receive $veBAL, which they can lock up for up to 1 year. $veBAL holders receive 65% of the protocol fees and can vote on pool issuance and other governance proposals.

The growth in the percentage of veBAL locked over time demonstrates a strong desire to take advantage of the system.

Options Liquidity Mining

In addition to “normal” liquidity mining, another alternative token model is option liquidity mining. In simple terms, this means that the protocol distributes liquidity incentives in the form of options instead of native tokens.

Call Options are financial instruments that allow users to buy an asset at a certain price (strike price) within a specific time. If the price of that asset rises, the buyer can use their option to buy the asset at a discount and then redeem it at a higher price, thereby making a profit on the price difference.

Option liquidity mining allows protocols to distribute liquidity incentives in the form of call options instead of native tokens. This model aims to better align incentives between users and protocols. For users, this model allows them to purchase native tokens at a greater discount in the future. At the same time, protocols benefit from reduced selling pressure and can customize incentive conditions based on their specific goals. For example, long-term incentives can be created by setting a longer expiration date and/or a lower strike price.

Options liquidity mining offers an innovative alternative to traditional liquidity mining. While this model is still fairly new and untested, some protocols trying to lead the way are eager to try it out, one of which is Dopex. They recently announced that they will test a call option incentive model for their structured products, claiming that this model will bring greater flexibility, price stability, and long-term participation compared to traditional incentive models.

However, there are also concerns that this process will discourage users in general. After all, DeFi has long been dominated by liquidity mining, and introducing these additional steps may put users off and keep them away from a project, especially if they don’t believe that the token will actually perform well in the future.

Will options liquidity mining help projects attract more long-term participants, or will the extra steps in the redemption process discourage users, thereby reducing liquidity? These are questions that need to be observed and evaluated.

Berachain

While the above examples provide some interesting models for maintaining liquidity and users, they are all focused on the application layer. So what if liquidity incentives were solved at the consensus layer?

Berachain is a newly launched project that aims to do just that — building a sustainable incentive structure within the chain itself.

It all starts with the “three-token model” — the gas token ($BERA), the governance token ($BGT), and the native stablecoin ($HONEY).

The novel Proof of Liquidity consensus mechanism enables users to participate as validators by staking their assets to Berachain in exchange for block rewards and LP fees.

When users stake their assets, their deposits are automatically paired with the $HONEY native stablecoin on the native AMM. At the same time, they also receive governance tokens ($BGT). $BGT stakers in turn receive protocol fees and have an impact on emissions and other incentives within the ecosystem over time.

In theory, this would create a positive flywheel effect:

  • More deposits = deeper stablecoin liquidity;

  • Deeper liquidity = more traders will use Berachain;

  • More traders = more protocol fees = more rewards for $BGT holders;

  • Better $BGT rewards = higher $BGT demand.

This model incentivizes users to keep their assets within the Berachain ecosystem as there is a greater opportunity for yield than elsewhere. The beauty of this model is that the primary beneficiary of the value generated by the chain is the ecosystem itself, rewarding participants with long-term commitment. Users begin contributing to the liquidity of the native stablecoin as soon as they deposit, naturally creating a liquidity mechanism. Additionally, users holding $BERA earned through block rewards can earn fees generated by on-chain activity by holding $BGT. Protocols may begin accumulating $BGT for voting rights, directing incentives towards their specific assets, paving the way for a potential Curve Wars-style ecosystem boom.

Curve Wars helped Curve grow into the DeFi giant it is today, can Berachain see similar effects?

Summarize

DeFi is still young and raw, and there is a lot of work to be done in its current state. Creating a sustainable economic framework is an important part of this process. It can be said that given that liquidity mining is so important to the fundamental nature of DeFi, it is impossible to abandon it completely.

However, alternative frameworks like the one described above suggest that the yield farming framework can be optimized to maintain liquidity and users, and actually benefit the ecosystem in the long term.

Next time you want to jump into your favorite DeFi project and look for yield, take the time to understand where the yield is coming from and whether it is sustainable. A little tip: If you don’t know where the yield is coming from, then you are the yield.