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Revisiting DeFi innovation: the birth and development of liquidity-as-a-service protocols

Messari

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Alternatives to Liquidity Mining: The DeFi 2.0 Wave is Coming

Original title: "DeFi 2.0 is coming, which projects are driving DeFi innovation?"

Original author: Chase Devens, Messari analyst

Original translation: Unitimes

After a long period of stagnation, DeFi has reappeared in the mainstream narrative in the cryptocurrency field. This revival is mainly led by the controversial term "DeFi 2.0", which was coined by Scoopy Trooples, the developer of Alchemx Finance.

In a recent Twitter thread, Scoopy highlighted some of the DeFi 2.0 protocols that were built on the innovations of the first generation of DeFi protocols, such as MakerDAO, Uniswap, Compound, and Yearn. However, this categorization sparked infighting over the classification of DeFi protocols and diverted attention from the actual changes that took place at the bottom. The comments following the tweet were in chaos, with everyone asking questions about their favorite Olympus DAO fork.

Instead of discussing the differences between arbitrary nomenclatures (DeFi 1.0 vs DeFi 2.0), let’s take a step back and examine some of the macro themes driving the latest wave of DeFi innovation. Today, we’ll explore the birth of Liquidity as a Service (LaaS) protocols and the rise of protocols that automate, enhance, or extend existing DeFi economic models.

01. Liquidity as a Service (LaaS)

Liquidity mining was the heart and soul of the DeFi summer of 2020, but this incentive method has fallen out of favor recently as protocols grapple with the aftereffects of mercenary liquidity providers (LPs) draining value from their systems. The liquidity mining model provides short-term incentives to LPs and generates permanent expenses on the protocol's balance sheet. As a result, DeFi projects are realizing that they need better systems to ensure sustainable liquidity while aligning long-term incentives for investors.

As this problem became more known, projects began to specialize in Liquidity as a Service (LaaS): by using LaaS providers, protocols can buy liquidity directly from the market, or rent liquidity from protocols that aim to provide the cheapest but highest quality liquidity.

1. Olympus Pro

Olympus DAO is the first project to use its novel bondization mechanism to create a viable alternative to liquidity mining. By issuing its native token OHM at a discount, Olympus is able to buy LP positions from the market, creating "Protocol Owned Liquidity" (POL).

Specifically, the "bond" structure in Olympus DAO is to incentivize liquidity providers (LPs) to sell their LP positions to the Olympus DAO protocol in exchange for the protocol's native token OHM at a discount in the future, which is actually equivalent to bondizing the LPs' LP positions.

That is to say, Olympus DAO will not obtain short-term liquidity by newly minting tokens like the previous liquidity mining model, but will subvert the liquidity mining model and encourage LPs (currently including liquidity providers of OHM-DAI, OHM-LUSD and OHM-FRAX on Sushiswap) to permanently sell their LP positions to the Olympus DAO protocol in exchange for OHM at a discount.

The specific implementation method is that after LPs provide liquidity to Sushiswap pools such as OHM-DAI and obtain LP positions, they go to the Olympus DAO website to "bondize" their LP positions (actually sending their LP positions to the Olympus DAO fund library). At this time, the protocol will quote the LP position and introduce a 5-day waiting period (vesting period). After the expiration, LPs can exchange their "bonds" for discounted OHM tokens.

Through this strategy, Olympus has purchased most of the liquidity of several OHM liquidity pools on Sushiswap, which has realized the "liquidity owned by the protocol" mentioned above. The recently launched Olympus Pro service marks the first LaaS product in the DeFi space, bringing Olympus’ bond model to the broader DeFi ecosystem.

Olympus Pro provides projects with a custom implementation of the Olympus Bond mechanism, while also introducing a new channel of demand for their native tokens. Projects that purchase their own liquidity will receive any revenue generated by trading fees, but also bear the impermanent loss associated with price changes. This approach may be best suited for larger projects with less volatile token prices, which can minimize impermanent loss. 2. Tokemak Unlike Olympus, Tokemak is a protocol designed for liquidity provision. At a high level, Tokemak will act as a decentralized market maker. Tokemak's native token, TOKE, represents tokenized liquidity and is used to influence the flow of its liquidity.

Specifically, like traditional DeFi protocols, in the Tokemak protocol, users (liquidity providers) can deposit idle assets into Tokenmark's comprehensive token pool (that is, provide liquidity) and obtain TOKEN token income, but the special thing about the Tokenmark protocol is that the Tokemak protocol guides the liquidity in the comprehensive token pool through its TOKE: users holding TOKE vote to decide which exchange to guide the liquidity of the Tokemak token pool to by staking tokens, and gain income in the process of guiding liquidity.

That is to say, owning TOKE means having the right to decide on liquidity, because TOKE holders (by staking tokens) can control the flow of liquidity and decide which market gets liquidity.

This means that other projects can get TOKE rewards by depositing their own tokens into the Tokemak ecosystem, then pair the token with assets such as ETH, USDC in the Tokemak liquidity pool, and pledge TOKE tokens to direct their liquidity to any venue they need.

Since this liquidity is ultimately controlled by Tokemark, the Tokemak protocol earns transaction fees associated with these controlled assets, but also bears any impermanent losses. From the perspective of other projects, this approach is most similar to liquidity mining, because these projects are still "renting" Tokemak's liquidity, will not receive transaction income, and will not face impermanent losses; however, this approach allows these projects to obtain TOKE token rewards without incurring permanent costs through liquidity mining.

3. Fei Protocol's cooperation with Ondo Finance

In addition to improving its core stablecoin protocol, Fei Protocol recently announced plans to cooperate with Ondo Finance to provide cheap short-term LaaS options for DeFi projects. Other protocols will be able to deposit their native tokens in the Ondo liquidity fund for a specific time and pair their deposits with newly minted FEI stablecoins. This token pair is then sent to an AMM (Automated Market Maker) for liquidity provision. This design by Fei Protocol and Ondo Finance is attractive to projects that want to generate on-demand liquidity for their tokens without having to incur the upfront cost of acquiring the other token in the pair. In exchange for providing the other half of the liquidity position (i.e. providing the FEI stablecoin), Fei Protocol charges a small fixed fee. Since these other projects act as liquidity providers (LPs) themselves, they are entitled to trading fees but also face potential impermanent loss. Ultimately, Ondo will return the token liquidity provided, plus the net trading fee income and minus the impermanent loss. This strategy provides a new way for other projects to strategically provide liquidity in a short period of time at a very low cost.

In summary, LaaS (Liquidity as a Service) providers are introducing methods to create sustainable liquidity at lower protocol costs. Although each approach has its pros and cons, it is becoming increasingly clear that LaaS is in the early stages of freeing the current DeFi system from its reliance on liquidity mining.

02. "Second order" protocols

The second category of projects that are currently reshaping DeFi is what I call the "second order" protocols. By leveraging the composable nature of DeFi, these projects build on top of existing DeFi infrastructure to automate, enhance, or extend existing DeFi economic models and processes. Because they sit on top of existing "money legos", their utility comes at the cost of compounding risk.

1. "Automation as a Service" Projects

The "yield as a service" platform pioneered by Yearn Finance provides an automation strategy for other projects to adapt to other specialized functions in the entire DeFi field: that is, finding a process with low time and gas fees and packaging this process at a small cost. In return, the ecosystem becomes more accessible and efficient.

Now, some projects are being built to automate specific micro-processes in DeFi. For example, the cross-chain liquidity protocol Popsicle Finance provides users' deposited assets as liquidity to other protocols to optimize users' returns. The protocol manages liquidity positions on multiple exchanges and L1s; Convex Finance recycles CRV and Curve LP tokens to increase rewards, transaction fees, and governance functions; Pickle Finance provides automatic compounding services for yield aggregators that lack automatic compounding functions. The emergence of these projects that provide automation as a service proves that if a specific problem is not solved, new participants will step in to do the work.

2. DeFi projects that enhance existing models

The first iteration of DeFi protocols created some 0 to 1 innovations that are now the cornerstones of our programmable financial system. Some of the most well-known examples include Maker (collateralized debt positions, or CDPs), Compound & Aave (decentralized money markets), Uniswap (automated market makers), and Yearn Finance (yield aggregator).

Unlike the innovations of these first-generation DeFi protocols, there are some new DeFi projects that enhance existing DeFi models without introducing any new operating models. These protocols reuse the achievements of existing DeFi protocols to provide more optimized models for end users.

Image source: Abracadabra.money

The fastest growing project is the cross-chain stablecoin protocol Abracadabra.money, which is an excellent example of enhancing and reusing an existing model by using interest-bearing assets to create CDPs. This CDP model was originally introduced by MakerDAO as a way to create a permissionless credit system, where users mint Dai, the Maker Protocol's native stablecoin, by using various overcollateralized vaults. A common criticism of Maker is that its CDPs are capital inefficient because assets remain locked in vaults and do not earn any interest. To improve the efficiency of the CDP model, Abracadabra minted its own stablecoin MIM using existing yield-generating assets (such as yvUSDT, yvYFI, yvUSDC, etc.) as collateral. This not only puts users' idle assets to work, but also provides borrowers with deeper liquidation support. As collateral continues to accrue interest and notional value in Abracadabra, the probability of liquidation decreases over time, although it will never be zero. While enhanced protocols like Abracadabra do not introduce any new primitives to DeFi, such projects have found product-market fit by improving capital efficiency.

3. DeFi projects that extend existing models

There is also a new class of DeFi protocols that introduce similar 0 to 1 innovations as DeFi 1.0 protocols, creating new overall value for the entire DeFi system. Unlike DeFi 1.0 protocols, these new primitives can only be achieved through stacked DeFi protocols.

Alchemx Finance is an example of extending the existing DeFi economic model. At first glance, the interest-bearing asset-based CDPs model used by Alchemix looks very similar to Abracadabra, however, some subtle differences allow Alchemix to create a capital-efficient, over-collateralized model that is not susceptible to liquidations.

In the Maker and Abracadabra models, liquidations are always a possibility because the value of their collateral is denominated in an underlying asset that is different from the issued stablecoin (Dai or MIM). Unlike Maker and Abracadabra’s multi-collateral stablecoins, Alchemix’s loans are in the form of synthetic assets of their underlying collateral, making them denominated in the same underlying asset.

For example, ETH loans in the Alchemix protocol are issued in the form of alETH, a synthetic asset with a price anchor to ETH. This allows Alchemix to remove price risk from its model and ensure that there is no possibility of liquidations. Therefore, the entire collateral in Alchemix can be used throughout DeFi, providing a sustainable source of loan repayments. While many will point to "self-repaying loans" as the primitive for Alchemix, the protocol's extension to existing DeFi protocols is that Alchemix reduces the opportunity cost for users when choosing between spending and storing their own crypto assets. Another group of protocols that extend the existing DeFi model take DeFi derivatives and break them up into separate pieces. Examples of such projects include Pendle and Tranche Finance. This optionality provides users with more customization and hedging strategies. These projects are few in number given their high level of innovation. However, the unique attributes of these projects may serve as the seeds for creating DeFi "killer apps" that bring the masses into the world of DeFi.

4. Compounding Risk

The rehypothecation methods used by the three new DeFi protocols mentioned above are not without trade-offs. The composable nature of these secondary protocols causes them to have compounded risk (compounded risk). If other protocols that are closely related to these protocols are attacked, then these secondary protocols will also collapse. This forms a house of cards structure, and the failure of any one foundational pillar will cause the entire tower to collapse. All other things being equal, the value added by these secondary protocols is offset by the risks introduced by composability. Although many projects use optimistic marketing, it is important to understand that the risks are greater than ever in secondary protocols.

03. Conclusion

The categorization of the new wave of DeFi listed in this article is not comprehensive. In addition, while some protocols may be groundbreaking innovations, they do not fit into these broad categories. One example is Rari Capital's Fuse product. Fuse takes the interest pool model of Compound and Aave and applies it to a granular level, allowing users to create interest pools with any combination of assets through the use of reliable oracles. Although the protocol is not a LaaS provider and is not directly built on other protocols, it still provides meaningful innovation by introducing a permissionless interest pool structure. LaaS providers and secondary protocols also do not define the characteristics that should be called "DeFi 2.0". At a time when the DeFi field is undergoing such rapid development, trying to put an all-encompassing label is not something that should be done proactively. We can leave this work to future historians. If we’re lucky, we can still make it another full year before the inevitable name “DeFi 3.0” is given to this space.

This article only represents the original author’s views and does not constitute any investment advice or recommendations.