How to increase DeFi mobility loyalty?
The Liquidity Loyalty Problem
By Luke Posey
Odaily
Total value lock (TVL) isDeFiThe most popular and misunderstood indicator in the world. Total capital allocation (TCA) may be a more accurate term. TVL implies that the value is "locked in" in the agreement, loyal and firm. Unfortunately, for many projects, this is not the case. In the short termcurrencyThe gameDominate. With the exception of a few blue chips, all statements guide prices. Narrative, price and liquidity are all highly reflexive.
In this article, we refer broadly to liquidity as all liquidity associated with the project -- liquidity of its governance token trading pairs, all relevant liquidity measures in its protocols, and so on.
In this article, we look at liquidity disloyalty by demonstrating the following:
Liquidity is sticky only in high quality projects. Loyalty is also fleeting compared with traditional stock markets.
The nature of unlocking early liquidity for everyone created a huge risk premium. That's not bad per se, it's just different.
By design, early liquidity is less loyal than late liquidity.
Token incentives that drive liquidity are bandage solutions that stimulate network activity and liquidity. The attractiveness of governance depends on the values and reputation it manages.
We will offer a range of items that can be takenpolicySteps to do this to appropriately align incentives and attract more loyal liquidity providers and loyal token holders.
Act ONE: Understand what drives DeFi liquidity.
TVL as an advanced indicator is a good indicator of the overall interest in putting money into DeFi over time. From DeFi Summer(2020) to the second quarter of 2021, DeFi's capital growth significantly outpaced Ethereum's. Returns are easy to find and liquidity is happy to stay in risky pools. The underlying governance token of the project has healthy liquidity due to the popularity of pledge pool 2. DeFi has exploded and TVL has significantly outgrown itETHThe market value.
Since then, cryptocurrencies have retreated from ATH's boom. As a result, the shift from risk initiation to risk closure begins and the corresponding returns are compressed. The flow slowly flows out of pool 2 into the stable. If we putAaveandCompoundThe stable pool acts as a risk-free rate due toStable currencyWith plenty of liquidity and limited borrowing, yields have been squeezed to record lows. Risk premiums in the risk pools above these yields are also subdued.
In the meantime, almost all risksinvestmentEarnings have been affected. In most cases, token prices fell by more than 60% and resulted in a corresponding drop in yields as the rewards to liquidity providers were paid in collapsed tokens.
The risk of contingent losses (IL) forced many liquidity providers (LP) out of these pools, depleting liquidity and creating a natural seller. Over time, as prices continued to fall, more and more LP surrendered. Despite the elevated IL risk, liquidity on these farms has declined due to lower prices.
When many LP's left Pool 2 for adventure, they found themselves in the stables, looking for new revenue streams. While DeFi has moved away from risk, flights through space have reached historic levels. The demand for stablecoins is pretty much constant.
Many of these staboins are firmly on-chain, creating attractive staboin opportunities in DeFi, or poised to increase decentralizationexchangeVolume to deal with cryptocurrency risks.
This shift to stable assets means that liquidity in risk pools has largely dried up. And risk pools have suffered from low user loyalty. Nathan Research recently reported on a liquidity mining initiative supported by SUSHI (MasterChef). Unsurprisingly, mobility on most farms is very volatile. At MasterChef, half the farmers never spend more than 15 days on the farm. The chart below shows the distribution of days of mobility providers on individual farms.
Nansen MasterChef Farm Duration study.
Such infidelity is not surprising. Liquidity providers watched as fickle losses ate their lunch. Take the buy-and-hold strategy of the popular governance token ALCX. Holding the token at $1,800 gives a net return of -80%, or about -70% once ALCX's unilateral pledge is taken into account. However, the liquidity provider in the ALCX-WETH pool caused a loss of -65% for LP, achieving a comparable return at higher risk and significantly higher overhead.
IL simulator
Curve, Aave, and Compound dominated TVL during this period because almost all of their liquidity was concentrated in stablecoins. But naturally, the increase in liquidity was followed by the aforementioned low interest rates.
Curve and the likeDEXArguably the only game with a stable pool of relatively low risk and attractive returns, this capital continues to be abundant. The fight for the benefits of Curve became so intense that it was Yearn, Convex and StakeDAOContinuously purchase and allocate a large number of Curve governance token CRVS to get the best possible return on Curve meters. These measurements are controls over how daO-controlled rewards are allocated in the Curve pool. Lock-in CRVS (veCRV) vote on how to divide these rewards.
Data source: Dune Analysis
Curve creates perhaps the most powerful incentive structure in DeFi, incentivizing liquidity with governance tokens. Their use of CRV in meters resulted in a large supply being allocated for production purposes, effectively locking up the vast majority of their token supply for a long time.
Data source: Dune Analysis
This creates a powerful feedback loop that allows tokens to retain value despite constant and relentless selling pressure. Countless parties continue to mine and dump these tokens on the open market. Most other projects are not so lucky. Curve's abundant liquidity and first-mover advantages make it continuously and strongly utilized in a stable capital pool.
Most governance tokens have not experienced the same fate. Like the anonymous tokens below, sparse use and thin liquidity tell a consistent story:
With liquidity almost exhausted, tokens now experience sharp daily swings at any sign of a buyer or seller. Continued selling pressure remains as these governance tokens are rewarded through liquidity incentives. The program relies on governance tokens to incentivize usage and stay competitive.
Act TWO: The current token design is an inevitable mid-life death spiral for most "greedy" protocols.
It can be problematic for teams that do not disclose stablecoins to disclose their own governance tokens, especially if the team is paid in project governance tokens. Potential feedback loops exist:
Hired farmers with limited loyalty, short-term lock-in venture capital, and team members with rent to pay are constantly selling new tokens to the market.
Prices fell in response to increasing selling pressure.
The team must pay more and more tokens to keep the same dollar salary.
Farmers also saw their returns suffer, either exiting, drowning their positions, or raising capital to cope with volatile losses and lower returns from falling token prices.
As more and more tokens are sold on the open market, further issues continue to depress prices.
Over time, liquidity exits the pool because their positions are simply unable to withstand volatile losses, or they start to lose confidence.
Retail investors and venture capitalists question their confidence in the project. Many pulled out and drove prices down further.
Liquidity has gone through a death spiral, and pool 2 of projects is now effectively dead.
Due to the inherent risk and transient loyalty of early projects, more and more teams are encouraged to spread their assets among more risk-averse assets. There are trade-offs, of course. It was the community that questioned the team's trust in their project. It may be better to diversify funding earlier in the project's life cycle.
If farmers and other stakeholders are motivated to engage in employment practices, what incentives guide teams, users, and investors to hold governance tokens and provide ongoing liquidity? There are many factors, but the main ones are:
Current or future cash flows are rewarded in the form of fees, token burning, buybacks, etc.
Marginal buyers drive up token prices (narrative driven prices, usually cash flow-driven narratives -- note the reflexive nature of this relationship).
Governance as the sole motivation for token holders is an illusion. This is a weak attempt to evade regulation and buy time on the real cash flow of the deal.
Token holders expect more. They expect liquidity in the future. In traditional markets, we often see liquidity premiums. Liquid assets trade at a premium because investors can cash out. The same is true of cryptocurrency assets. Projects without liquidity commitments increase risk and reduce loyalty -- just as TradFi market makers may avoid additional risk on their books by how they forecast, DeFi's retail and specialist liquidity providers are constantly monitoring risk. DeFi tends to be less mobile, which makes loyalty scarce.
A lack of liquid loyalty means flight at the first sign of danger. Risk aversion signals a decline in the price of tokens. The decline in token prices signals the withdrawal of liquidity, and the withdrawal of liquidity signals the decline in token prices.
Act THREE: The new paradigm of early liquidity has not failed; Just different.
One of the signature innovations of the crypto revolution is expanding access to early-stage liquidity. In many ways, this is the democratisation of venture capital. The traditional model has been for up to a decade for retail investors to gain access to companies through ipos, direct listings and the like. Traders and investors can now access early liquidity at what can be said to be the pre-seed and seed stage through ICOs, IDO and early DEX liquidity.
Arguably, this early liquidity led to a large price premium. Valuations in the sector are wildly inflated. Arguably, this makes sense, since venture investors can get an inherent liquidity premium at any stage through publicly available DEX liquidity. They do not have to wait another 10 years for an exit event. Many venture capitalists salivate at the chance that even a failed project will still have plenty of retail exits. The winner will earn more than 100 times, and even the worst loser may have a shuffle, a small profit or a recoverable loss.
That creates a huge premium, and many venture capital firms are vying for a share of early investments. However, as the premium continues to inflate, the valuation will exceed the value of the premium.
Early stage capital is by design less mobile. Venture capital intentionally involves lock-in periods and limited liquidity. Secondary markets exist for exposure, but ultimately, in traditional venture capital, lock-in and long-term marriages between companies and investors are key. High-quality teams are asking investors to extend lock-up periods, and cryptocurrencies will soon face liquidation. A six-month lock-up period is simply not enough. Venture investors can easily cut their losses and abandon ship, selling their shares to an open market once their tokens are unlocked. They take reputational risks, but short-term capital risks are still far more important.
But the pendulum on this topic may have swung too far in punishing the behaviour of venture capitalists. In many ways, the new model makes all retail investors risk investors. The investment phase of retail has historically been the preserve of venture capitalists. If we were to impose lock-ups on venture capital, perhaps the team could explore expanding lock-ups in the retail industry. Teams issuing governance tokens in IDO as well as through holding pool 2 DEX positions should explore lock-up periods for these governance tokens, extending them by 1-5 years and improving returns.
After all, these projects and investors are going to be around 1-5 years, right? The answer is usually no. Teams and investors who prefer short-term incentives should expect increased risk as they reap potential short-term rewards.
Sell a basket of early product governance tokens long term bullishoptionsMay be wise. This is not because these projects are likely to fail, but because the risk premium will be repriced over the next few years as they demand a higher value for each project sold.
Act four: Adjusting incentives is a complex game that requires careful consideration of the desired outcome.
Biology describes three symbiotic relationships in nature:
Reciprocity: Both parties benefit.
Symbiosis: one party benefits while the other does not suffer.
Parasitism: One party benefits and the other suffers.
In the initial stages of the project, almost all participants were involved in mutualism. When the project was launched, the earliest investors and liquidity providers took on higher risks. These early investors are often vocal supporters and assist with marketing, development efforts, analytics, and more. Mutualism.
Somewhere in the life cycle of these projects, the relationship becomes symbiotic, with marginal token holders no longer guiding the network and now taking less risk and expecting a return. They tend to be less involved in the community. If they provide liquidity, then liquidity is usually less loyal. If their profits and running impact on the project is marginal at best, their personal gains can be huge. If their positions are liquidated, the projects will benefit from their liquidity, but the investors will suffer. Symbiosis.
Finally, the third type is parasitism. They acted purely for short-term results. They engage in extractive governance practices. They only pursue what is good for them. They employ dubious marketing tactics and rely on their influence to persuade marginal investors. From an investor's point of view, this may be an investment in private financing that pursues a large allocation, short-term lock-up and contributes little to the project. On the project side, it may be a community-wide project, or it may never reach a development milestone. Parasitic.
For now, many in the field think that time is too short. But maybe it's ok. We are still in a cycle of rapid innovation. Short-term thinking and outdoing your competitors can be very profitable. As more quality comes into the field, long-term thinking will become more lucrative.
The loyalty of mobility depends on the potential users of the project. These types of users will change as the project matures. User behavior today is highly variable. For good reason. Innovation is moving too fast for mobility to be combined with a team or code base. Perhaps over time, more moats will form and innovation will slow down. For now, pooling risk and radicalisation is a fool's errand.
Act five: Through sensible policy, loyalty mobility is possible, though it requires trade-offs.
With the right incentives and agreements and collective buy-in from investors, projects can succeed on their own.
Pending some policy recommendations, what is the surest way to maintain liquidity? Utilization.
If there are no users for the underlying product, token economics doesn't matter.
Utilization - Dig deep into utilization, and many projects and networks are truly "ghost towns." They have an active governance token portfolio in DEX, but there is no reason to keep that liquidity loyal.
Narratives are fragile if not exploited. Cash flow is sparse without utilization.
If used properly, the narrative is more robust. Utilizing cash flow is abundant. Our previous chart changes...
Because of the feedback loop above, I think projects with long term goals should wait longer to launch tokens or provide DEX liquidity. Pre-product projects either insist on looking for private capital commitments to lock in tokens from transactions, or accept the risks/trade-offs of providing early liquidity to their communities. If not, be prepared for a chaotic ride. Note that even most projects with functional products fail to attract significant user growth and utilization of their protocols.
So far, we have been able toSushiswapAs the pinnacle of blue chip DeFi. Even Sushi is struggling with user retention. Now imagine not a peak blue chip project.
Data source: Dune Analysis
Despite the plethora of rewards, innovation, top brands, and a strong community-driven strategy, Sushiswap's user retention remains low.
Only a few projects show strong utilization and cash flow. Ironically, incentives are actually the most fundamental of many of these incentives, mainly because they can be done.UniswapIs an obvious example. Uniswap has no liquidity incentive in its product. Base utilization drives fees, and these fees drive liquidity providers to participate.
UNI token holders are not being promised anything, although the prevailing mood is expectations of future cash flows.
Although many projects using UNISWAP-V2 liquidity offer collateral, V3 has managed to attract liquidity and usage of the entire product purely due to the advantages of usage costs. Capital efficiency and product advantages are consolidating DEX's total dominance.
Data source: Dune Analysis
In addition to the high liquidity of all currency pairs, governance tokens themselves are also highly liquid. Uniswap tokens are in highest demand in DeFi. Utilization is (almost) everything. Without it, any short-term return is merely a temporary measure of long-term fate.
Have liquidity.
A unique way to achieve loyalty liquidity is to keep it in the hands of the project itself by owning the project itself. Let users buy and sell tokens, but take steps to hold a significant portion of your own liquidity. OlympusDAO is a perfect case study.
OlympusDAO proposed the first solution to the loyalty liquidity problem. The DAO holds more than 99% of the liquidity in its reserve currency. It does this by selling bonds at a discount in tokens. The maturity of the bond is 7 days. It sold the bonds to gain a Sushi active position (SLP), or a stable position. Over time, selling SLP bonds would increase DAO's ownership of liquidity, which currently holds more than 99% of SLPS for Ohm-Dai and Ohm-Frax.
Data source: Dune Analysis
For OHM, that means standing behind its reserve currency. For other projects that choose to issue bonds, that could mean a dedicated fund to pay for itdevelopersAnd marketing.
It is expected that over time, more projects will adopt this autonomous liquidity structure, taking increasing LP positions by selling bonds in their native tokens. Moreover, having the project's own liquidity allows it to constantly collect fees from the pool. In this way, even if the tokens experience downside volatility, they are hedged by charging fees.
Codified loyalty. Accept the trade-off of slower growth.
Several different methods of locking, authorization and so on have been tried in DeFi with varying degrees of success. Main is:
Lock unilateral pledge position, liquidity position incentive mechanism revolving door, longer lock-up period incentive mechanism, etc.
The redemption period of the token reward can distract the seller from the pressure/delay
Reached a private agreement with investors to become a market maker for DEX LP and CEX.
Expand access to derivatives for LP positions. More flexible hedging means less need to exit positions.
The easiest way to mitigate the liquidity shock is to lock-in. Although unilaterally locked pledge positions do not directly stimulate liquidity, they soften the blow to capital allocators. Take CREAM as a good case study. A gradual increase in APY over a longer time frame would incentivize pledgers at all levels. Although liquidity is low, selling pressure remains at healthy levels as token holders remain stable and liquid loyal.
The 4-year lock-up period promises the most tokens, with about 10% of 3M's circulating supply in the 4-year lock-up period. Each layer locks fewer and fewer tokens. The pledgee can be rewarded with health, and the agreement softs the blow by kicking the can down the road.
The expectation of a project is that in four years, they either find their purpose and experience healthy growth, or they fail completely. If they experience healthy growth, liquidity is strong; Any large token holder will have a lot of liquidity for four years if they want to. If they fail, the debate about liquidity will be silenced.
So far, CREAM's healthy and continued growth of users/lenders, combined with loyal capital, is a winning combination for CREAM's market cap, but the project's liquidity is thin, especially during this risk-off period at DeFi. Holders would rather hold tokens than risky LP positions. The good news is that liquidity is growing at CEX,FTXAnd Binance both provide a healthy market for CREAM/ staboin pairs. But for this project, the total liquidity of DEX and FDV is still low.
"How can I help you? -- Anonymous VC
A small number of crypto VCS are highly technical, and their tech niches are scattered between research,security/ Auditing, token economics, etc. The vast majority of vc firms are low-tech and use capital as their primary means of adding value. Smart founders who receive a lot of money from new investors should explore formal agreements with investors to provide liquidity, preferably in the base pair, but guided utilization elsewhere can also indirectly fuel the growth of the network, thereby generating interest in the base pair.
In a loan agreement, this could mean that the investor is the first to deposit in the loan market, initiating a staboin pool of $500,000 to several million dollars or the underlying token of the agreement to encourage others to follow. In DEX, this may mean increasing capital on a strategic basis and is likely a symbol of the project. Founders shouldn't be afraid to ask investors to participate in these plans and lock in any return they get from putting money into them. More than one smart founding team recently turned down investors who couldn't commit to rewarding lock-up periods. Don't be afraid to get more from your earliest investors.
Finally, opening up the derivatives pipeline improves the flexibility and loyalty of liquidity providers (LPS). All things considered, many LP's would prefer to follow this ship regardless of the outcome. Shifting positions creates tax liabilities and adds complexity. Currently, most LP's either have limited access to cryptography derivatives or don't have products that fit their desired R/R configuration.
LP can use derivatives to hedge positions, preserving some returns on the upside and protecting capital on the downside. Greater access to derivatives will allow more LP's to stay in the business. For example, I might choose to continue rolling put options against the underlying LP position. Below we simulate the returns of various put options; Securing more options on our underlying assets, particularly in regulated environments such as the US, would be a positive step in the right direction, lending to more hedge liquidity providers.
Derivatives created specifically to hedge against short-term losses could also be an interesting product -- an idea we'll explore further in a later article.
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