Original: "Chasing 'Sticky' Liquidity"

Author: Paul Timofeev

Translation: Shenchao TechFlow

In the DeFi space, liquidity is crucial.

Liquidity refers to how easily an asset can be converted into cash. The higher the liquidity of an asset, the easier it is to cash 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 assets on automated market makers (AMMs) like Uniswap. Better liquidity can reduce price slippage, making transactions more efficient and benefiting all participants. Therefore, in DeFi, projects are motivated 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 seem to share a similar fate—liquidity and growth surge rapidly, followed by a noticeable decline. DeFi has learned painful lessons; acquiring and retaining liquidity over time is much more challenging than establishing liquidity in the short term.

As top market makers like Jane Street and Jump Trading gradually reduce their participation, the need for designing sustainable token models becomes even more important.

Liquidity comes… and liquidity goes.

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

But we soon realize that this practice is extremely unsustainable in the long run and is a poor business model. Protocols constantly 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, as an example. Despite generating $10.92 million in protocol revenue, they also paid nearly $75 million in token emissions, resulting in a loss of $63.96 million, or -63.1% profit margin.

DeFi needs to abandon unsustainable designs that fail to maintain liquidity and adopt more attractive token models that encourage long-term participation and growth. Let's explore some models aimed at optimizing the current liquidity state.

LP Gauge Tokenomics

Curve Finance introduced the VoteEscrow model, allowing $CRV holders to lock their tokens for $veCRV, granting holders governance rights and increased rewards.

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

Some protocols do not lock native tokens but instead build models focused on locking LP tokens.

LP Gauge economics incentivize liquidity-providing LPs to lock their LP tokens in exchange for increased rewards and greater governance rights. In this model, traders benefit from a "locked" liquidity safety net, LPs gain governance rights and larger rewards, and the ecosystem benefits from deeper liquidity.

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

Over time, the increasing percentage of veBAL locked indicates a strong demand to utilize this system.

Options Liquidity Mining

In addition to "regular" liquidity mining, another alternative token model is options liquidity mining. Simply put, this refers to protocols distributing liquidity incentives in the form of options rather than native tokens.

Call options are financial instruments that allow users to purchase an asset at a predetermined price (strike price) within a specific time frame. If the asset's price rises, the buyer can use their option to purchase the asset at a discount and then redeem it at a higher price, thus profiting from the price difference.

Options 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. Meanwhile, protocols benefit from reduced selling pressure and can customize incentive conditions based on their specific goals. For example, by setting longer expiration dates and/or lower strike prices to create long-term incentives.

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

However, there are concerns that this process may overall deter users. After all, DeFi has long been dominated by liquidity mining, and introducing these additional steps may discourage users and drive them away from a project, especially if they do not believe the token will perform well in the future.

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

Berachain

While the above examples provide some interesting models to maintain liquidity and users, they all focus on the application layer. What if liquidity incentives were addressed at the consensus layer?

Berachain is a newly launched project aimed at doing just that—establishing a sustainable incentive structure within the chain itself.

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

The novel liquidity proof consensus mechanism allows 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 native stablecoin $HONEY on the native AMM. At the same time, they also receive governance tokens ($BGT). $BGT stakers, in turn, earn protocol fees and influence emissions and other incentives within the ecosystem over time.

Theoretically, this will 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 are greater earning opportunities compared to elsewhere. The beauty of this model is that the primary beneficiaries of the value generated by the chain are the ecosystem itself, rewarding participants who commit long-term. Once users deposit, they begin contributing to the liquidity of the native stablecoin, naturally creating a liquidity mechanism. Additionally, users holding $BERA obtained through block rewards can earn fees generated by on-chain activity by holding $BGT. Protocols may start accumulating $BGT for voting rights, directing incentives to their specific assets, paving the way for a potential Curve war-like ecosystem prosperity.

Curve Wars helped Curve evolve into the DeFi giant it is today; can Berachain see a similar effect?

Conclusion

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

However, alternative frameworks as described above indicate that the liquidity mining framework can be optimized to maintain liquidity and users, and indeed benefit the long-term ecosystem.

Next time you want to enter your favorite DeFi project and look for yields, take the time to understand where the yields come from and whether they are sustainable. A little tip: If you don't know where the yields come from, then you are the source of the yields.