Liquidity mining is dead, where is the future?

Author: Andrew Thurman

Original Title: 《Liquidity Mining Is Dead. What Comes Next?》

Translated by: James, Chain Catcher

Liquidity mining was once the fastest-growing dark horse in the DeFi space, but with a wave of new projects emerging, is there still a way forward for liquidity mining?

At present, liquidity mining seems to have run out of steam, and various sub-industries in the cryptocurrency field are keenly searching for alternatives.

The main driving force behind the "DeFi Summer" craze in 2020 was actually liquidity mining, a concept where users provide liquidity to a platform, such as by staking stablecoins or valuable tokens, and then earn tokens sent by the platform as rewards through trading, lending, or borrowing on the platform.

However, in recent months, liquidity mining has become an "imprecise" incentive tool, even drawing fierce criticism from a group of Ethereum miners. As a result, a large number of new projects have begun to emerge as alternatives to liquidity mining, such as bonds, time-weighted voting systems, and stablecoin issuers focused on "DAO-DAO"—these upgraded projects are likely to permanently change the way DeFi protocols attract staking.

Depending on the project, one mechanism that may truly work is referred to as "liquidity as a service," or it could also be called "protocol-controlled value" or even "DeFi 2.0." Regardless of the name, the basic principle remains the same: managing the large amounts of capital acquired through incentive mechanisms.

These efforts seem to be attempting to answer a seemingly simple question: until now, "free" capital has been the underlying reason driving the application of DeFi. So what is the more precise method?

With the arrival of the new year, projects capable of solving the above problems have become the most favored by traders and investors. Despite the market downturn, protocols focused on attracting liquidity remain popular. Some believe this trend aligns with the development of Web 3, where value can be utilized and commodified like information on the internet.

In this regard, Fei Protocol co-founder Joey Santoro expressed his views: "Liquidity is king. The way I frame it is: the internet is controlled by services and information storage (cloud computing and data storage). When you translate that into DeFi, what you need is value services—lending platforms and automated market makers (AMMs). Additionally, you need value storage, which is liquidity management."

Whoever controls liquidity, controls DeFi

Other investment institutions, such as venture capital firm eGirl Capital, believe liquidity trading is outdated. Whether liquidity as a service ultimately becomes a trend, receiving temporary stimulation in the volatile cryptocurrency economy, or becomes a new cornerstone of on-chain market structure, at least for now, this arms race to control liquidity staking in the DeFi space is essentially a battle for a $230 billion industry.

Joey Santoro continued, "Liquidity is one of the two most important resources in this new world; whoever controls liquidity, controls DeFi."

However, liquidity mining seems to be outdated

From the perspective of using protocols, initially, liquidity mining seemed to represent the future of projects mining products that fit the market.

During the "DeFi craze" of summer 2020, the DeFi protocol Compound sparked this trend by using COMP tokens as rewards to increase the staking returns of its lending platform. With similar incentive programs, protocols like Sushi temporarily surpassed their competitor Uniswap.

However, critics have recently pointed out that while issuing large rewards to users will certainly stimulate staking in the short term, liquidity mining is not a perfect tool. It has also attracted what prolific DeFi developer Andre Cronje referred to as "liquidity locusts"—so-called "temporary miners" who, once the tokens are exhausted, take their rewards and move on to the next token pool.

Deribit Insights researcher Hasu stated in a recent podcast: "I think liquidity mining is one of the dumbest things that has happened in the crypto space so far."

Why is that? Because I believe there is no strategic consideration behind it. You should carefully think about 'What do we want to get from this? What does the target liquidity in the protocol look like? Once the target is reached, there should be no further rewards.'"

Are core users the key?

In contrast, a new batch of projects utilizing liquidity has made returns more transparent. They attempt to quantify how many dollars in token rewards have been paid within the protocol and how many dollars have been staked. In some cases, they have actually placed the protocol's liquidity under the direct control of a DAO.

The first alternative liquidity mining solution emerged by chance.

Automated market maker Curve launched its "vote locking" feature in August 2020, allowing CRV token holders to lock their tokens for up to four years in exchange for veCRV (vote-escrowed CRV). In turn, veCRV can vote on which liquidity pools can earn CRV rewards, with voting power skewed towards those who lock their tokens for longer periods.

During that time, it seemed to be a tool for individual miners to maximize their returns: by locking part of their CRV rewards, they could direct more rewards to their favorite mining pools, potentially leading to greater profits in the long run. However, the opposite has proven true, as other protocols have become the primary beneficiaries of this system, rather than individual miners. People are competing in what is known as the "Curve Wars" to accumulate CRV tokens.

According to an anonymous analyst, this vote-locking system—also known as the "Ve economic model"—"pretends to choose time preference but actually centralizes governance in those who can accumulate the most tokens."

In short, whoever accumulates the most veCRV controls the release of CRV rewards.

Currently, the "kingmaker" protocol controlling Curve rewards is Convex Finance. According to data from Dune Analytics, Convex holds 43% of the total circulating supply of CRV tokens, a staggering proportion, while in voting power, 1 governance token CVX from Convex is equivalent to 5.1 CRV tokens.

In fact, Curve and Convex are also the two largest protocols in DeFi, with a total locked value of $40 billion according to DefiLlama data.

The results are predictable; a "new industry" quickly emerged in the market: using platforms like Votium, where protocols can "bribe" vote-escrowed CVX holders to direct liquidity to the funding pools that matter to them.

In practice, "bribing" deposits has clear benefits for DeFi protocols.

For example, stablecoins like Terra's UST benefit from deposits in Curve pools, helping UST maintain a healthy, liquid market, keeping it pegged to the dollar, and creating utility for the stablecoin—achieving all the goals that liquidity mining programs might accomplish, while costs, returns, and targets become more transparent.

In fact, in a recent governance forum post, members of the UST stablecoin team concluded that the ongoing incentive deposits through CVX "bribing" are "progressing very smoothly."

Some say these benefits mean "DeFi Ve economics" may continue to exist.

Redacted founder 0xSami stated: "Assuming you are a stablecoin, the primary task of a stablecoin is to establish liquidity, so it makes sense to buy Convex tokens. Moreover, if you want derivative liquidity, you should buy the vote-escrowed tokens of Ribbon and use them for DEX liquidity in Sushi or Aave, so you can become collateral for loans, which will be a major trend this year."

Is "bribing" the DeFi ecosystem reliable?

After the emergence of the new "bribing" economy, many new products are about to launch, acting as governance or voting intermediaries in the evolving tech stack, dedicated to helping protocols route and control liquidity. These products include: Warden, Bribe, Llama Airforce, Votium, and Votemak.

Among them, Votemak was recently acquired by Redacted, and the governance market platform Bribe recently announced the completion of a $4 million seed round to help establish the VEV protocol, led by Spartan Group, with participation from Dragonfly and Rarestone Capital.

Frankly, part of the reason for the rise of these projects may be that other DeFi projects have implemented "variant" Ve economic models, creating more market demand for DeFi protocols to acquire liquidity through ticket buying—

Tokemak is such a project, aiming to become a decentralized market maker: users deposit funds and receive TOKE tokens as rewards, which can be used to vote on which DeFi protocols to deploy liquidity. Therefore, for those DeFi protocols looking to "bribe" liquidity, Tokemak has now become another target they are "eyeing." Meanwhile, other projects (such as Frax and Yearn) have also begun to experiment with introducing Ve-style economic models.

Bribe protocol's anonymous founder Condorcet stated: "Retail investors can understand what we are doing and the importance of it. They want to get bribed just like those behind them, so we did it." Tokemak will be one of the results of Bribe's first integration.

Unsurprisingly, the emerging industry has also caught the attention of venture capital investors. Ashwin Ramachandran from Dragonfly Capital, one of the investors in Bribe's recent funding round, stated: "We think this is a very interesting trend; in terms of liquidity mining programs, there will definitely be an order-of-magnitude improvement in capital efficiency and pricing, which may put excessive selling pressure on native governance tokens."

Token Control

While some DeFi protocols are playing the "bribing" game, trying to direct liquidity to funding pools that benefit them, other DeFi protocols have chosen to directly control liquidity—this is also an emerging trend of "protocol-owned liquidity."

The algorithmic stablecoin project Fei Protocol is collaborating with Ondo Finance (a DeFi protocol focused on mitigating impermanent loss risk transfer) to build a product that allows protocols to pair their native governance tokens in the treasury with Fei's stablecoin to directly create liquidity funding pools.

This means DeFi protocols can directly create liquidity funding pools, rather than relying on user deposits to generate liquidity funding pools—crucially, this also allows protocols to retain a portion of the trading fees from the liquidity funding pools, creating a new revenue stream.

This logic has already been applied in Olympus's bond program, Olympus Pro, where the Olympus protocol exchanges liquidity pool positions for bonds, allowing the protocol to control the liquidity of its tokens and earn trading fees.

Fei Protocol founder Joey Santoro explained that this is part of the emerging "direct-to-DAO" service, which allows third parties to help DAOs more effectively route their token liquidity and other needs.

Protocol-owned liquidity itself is also becoming a vertical domain, with Olympus and its various forked protocols, including Wonderland and Redacted, accumulating large amounts of CVX tokens and other tokens with "bribing" income potential, hoping to use the token reserves to generate returns in the future.

In a recent tweet, Wonderland protocol developer Daniele Sestagalli candidly stated that they are moving away from Olympus's criticized "annual yield scheme."

Meanwhile, 0xSami from Redacted expressed his hope that the protocol could become a "meta governance token," allowing projects to become single assets. In fact, Redacted has already begun to do this; for example, their "meta governance token" BTRFLY has played a leading role in multiple governance processes, with the protocol treasury earning fees through this service, which can then be redistributed through bonds or similar financial instruments. 0xSami further stated:

"Clearly, we now need high annual returns to gain a competitive advantage in the market, but once the treasury is established, the token doesn't even need to adopt a rebase distribution mechanism—because we can completely introduce a project with sustainable returns."

The example of interest here is the Avalanche protocol ecosystem project Wonderland. On January 7, it was reported that the algorithmic currency market Wonderland has made a seed investment in the decentralized betting application BetSwap based on Polygon. This move marks one of the first instances of community governance crypto projects investing in DeFi protocols. On January 11, Wonderland's treasury balance surpassed $1 billion, and soon after, on January 18, Wonderland conducted a large-scale buyback using its own funds, which may also be the first example of "quantitative easing" in DeFi projects.

Layer 2 Expansion

Strangely, until recently, most experiments with "liquidity as a service" have been concentrated on Ethereum. Many alternative Layer 1s are still running incentive programs, and they are still using traditional liquidity mining tools, making them highly inefficient—one could say that now is the best time to disrupt traditional DeFi models, and this timing is quite mature.

When discussing Ethereum alternative chains, Joey Santoro stated: "I think you will see exactly the same narrative—yield farming through the release of governance tokens will become a form of liquidity owned by DeFi protocols."

Allocating your tokens to a platform and then boosting the platform's future development—this is undoubtedly a very powerful concept.

In fact, DeFi protocols deploying the "Ve economic model" have begun to appear in other ecosystems. For example, Andre Cronje and Sestagalli are collaborating on an unreleased project based on Fantom, currently referred to as ve(3,3)—essentially a mix of the "Ve economic model" and Olympus staking program.

This unreleased project has shown tremendous popularity, but just this Tuesday (January 18), a new project called veDAO emerged, aiming to gain majority control of the ve(3,3) protocol, locking in a total value of over $785 million within just a few hours.

Meanwhile, Joey Santoro stated that Fei Protocol is planning to choose a Layer 2 to migrate its ecosystem, believing that this approach will be very beneficial for Fei Protocol and enable them to continue being a leader in the field of liquidity mining alternatives. Joey Santoro said:

"Fei Protocol will migrate to a Layer 2 we deem suitable, and we will also build L2; who can compete with a blockchain that has $1 billion in non-incentivized locked value?"

Where is the future headed?

While "liquidity as a service" is currently one of the fastest-growing areas in cryptocurrency, the question is whether "liquidity as a service" can become the future driving force for crypto projects, even among those working in this field.

Redacted founder 0xSami believes that projects like Curve and Tokemak, which have become liquidity hubs through incentive programs, will either capture a large share of the market or completely disappear in the future. He stated:

"For DeFi projects like Curve and Tokemak, either one becomes the ultimate liquidity hub, or the narrative exhausts, and then they fade away one after another."

In recent weeks, some analysts have also pointed out that while many DeFi protocols have higher locked values than ever before, Curve's stablecoin swap trading volume (which is also the cornerstone of its market share) has actually been declining as low-fee Uniswap v3 pools continue to encroach on Curve's "territory."

An anonymous analyst also expressed skepticism about the victory of the Ve-style economic model, stating that ve-tokens are not "optimized for the right things," but "liquidity governance and token release control are incredible." This analyst stated:

"This is Curve's greatest gift to the DeFi ecosystem—being able to allocate your tokens to the platform in the form of liquidity release is beneficial for driving future growth of the platform, undoubtedly a very powerful concept."

Meanwhile, Joey Santoro believes that the ultimate outcome of the DeFi market may not be a single winner, but a world with multiple competing joint projects, all possessing substantial liquidity.

"I can assure you this won't be a monopoly, but a bunch of competing ecosystems. This is part of the narrative of consolidation in the DeFi market. You will see Tokemaks, Olympuses, Tribe DAOs, and Curves absorbing liquidity and control, and DAOs aligned with them will benefit from it."

Even if the outcome is uncertain, some projects that emerged during the liquidity mining boom have shown us how to attract and incentivize users. Although the Ve-style economic model has certain misleading aspects, who wouldn't want to retain liquidity?

Joey Santoro concluded with a thought-provoking statement—

"I think there's nothing wrong with giving it a try."