Liquidity Mining: The Quantitative Easing of Decentralized Finance
The crypto's poster child is banking on good old Keynesian tricks
If you have ever taken a class in Economics, you had most certainly come across the debate between John Keynes and Friedrich Hayek on the extent a central planner should intervene in the economy. In case the names don’t ring a bell, here’s a rap battle that will take you on track.
Up until recently, there wasn’t a clear winner. Then, the 2008 credit crunch happened. Severe liquidity crisis and recession led to a structural change in the monetary regimes worldwide. Quantitative easing (QE), what was believed to be an unconventional and short-lived tool to stimulate economic activity, became a focal point to central banks. These liquidity injections are the cure of low consumer confidence, unemployment, export struggles… The QE turned into a universal panacea. The Austrian school of economics is dead.
Say it loud, say it proud, we’re all Keynesians now!
Born from the ashes of the financial crisis, Bitcoin surpassed the $1T mark mostly on the premise of being an inflationary hedge. And it is also far from the only blockchain-based project benefitting from investor’s attempt to steer away from the FED-controlled capital markets. The vibrant crypto ecosystem is thriving, pulling millions of dollars in fresh capital and high-profile talent each and every day now.
One particular subsegment that made the splash is Decentralized Finance (DeFi), and more precisely - Automated Market Makers (AMMs) / Decentralized Exchanges (DEXes). Experimental protocols like Uniswap and Curve managed to attract billions of dollars in a matter of months, if not weeks, using a simple, yet effective growth hack called liquidity mining.
The Economics of Liquidity Mining in Decentralized Finance
Pioneered by Compound and fine-tuned by Curve and UniSwap, liquidity mining is a subsidy in the form of governance/profit-sharing tokens, meant to sweeten the deal for the providers of a scarce resource to an ecosystem.
Taking the constant product AMMs as an example - the larger the liquidity pool, the more attractive it is to traders due to smaller slippage (transaction cost). This capital intensity translates into a strong competition between protocols to attract stakers for their pools. Furthermore, liquidity providers (LPs) should be compensated for the opportunity cost, technology risks, and (im)permanent losses they incur. An intuitive solution would be to charge users (the traders) a commission (trading fee) that is passed through to the LPs. The higher the rate, however, the less attractive the service becomes to traders, offsetting the benefits of the extra liquidity.
The rivery between protocols to offer LPs the best deal on the market gave birth to the proprietary incentive tokens like UNI, CRV, and SUSHI. Typically, these are newly created assets serving as a yield-enhancement tool and a monetization mechanism for protocol’s developers and investors. So far, the rule of thumb has been to divide the total supply between liquidity providers and active protocol contributors (investors, developers, active community members) in a 2:1 ratio, with a third of the tokens being distributed at genesis to support a liquid secondary market. The rest are kept under protocol’s custody and regularly emissioned to stakeholders.
To illustrate how liquidity mining works, consider you put $1,000 worth of wBTC and DIGG on SushiSwap. In return, you get a pro-rata share of the 0.25% trading commission collected by the pool and 0.022 SUSHI per day. The latter subsidy is what we refer to as liquidity mining.
Source: SushiSwap
By definition, these programs result in continuous inflationary/sell-side pressure that should be somehow counterbalanced to avoid price capitulation. Common techniques include equity-like features combined with efforts to locking the circulating supply:
Revenue-sharing: instead of distributing all commissions captured by the protocol to the existing LPs, most AMMs are funneling part of the trading fees to their token holders. The result is a cash flow generating asset with an intrinsic value tied to the economic activities of the protocol. Closely resembling company shares, these tokens allow investors to employ traditional valuation approaches and speculate with protocol’s long-term potential.
Voting rights: similar to company ownership, tokenholders are on the driving seat of protocol’s management and have the final say when an executive decision is made. In this regard, tokenholders are more privileged than shareholders of publicly traded equities as proposals are generally easier to make and vote for.
Supply-locking techniques: notorious for its aggressive inflation schedule, Curve coined a two-tier token system. The first - CRV, is the subsidizing asset that enjoys ample liquidity but lacks other utility features. veCRV, on the other hand, comes with revenue-sharing, voting, and discount rights. There is an easy-to-use one-directional bridge for every CRV holder that wants to take advantage of veCRV’s features. The catch is that once exchanged for veCRV, your CRV tokens are locked (hence illiquid) for a predetermined period of time (up to 4 years). The longer, the better. By soaking the liquidity, veCRV absorbs part of the selling pressure from existing tokenholders, allowing the protocol to sustain the aggressive inflation schedule without crushing the CRV price.
You must be spotting the irony: the poster child of an industry established on the premise of serving the need of the free, untampered market owe its success to the good old Keynesian tricks. Unsurprisingly, the Bitcoin maximalists are not that passionate about DeFi whatsoever.
The State of the Decentralized Exchange (DEX) Tokens
The incentive tokens in the Decentralize Exchange space are performing far better than expected. The subsidy they provide is luring record levels of capital which, in turn, makes the DEXes ever more competitive against the centralized alternatives (Binance, Huobi, etc). The constant product DEX design benefits exponentially from the improved liquidity due to the ‘winner-take-it-all’ nature of the business. Ultimately, low slippage equates higher trading activities and commissions raked by the decentralized exchange.
The table below clearly illustrates the thesis that the more inflation a project is able to sustain, the larger the protocol becomes:
Developers often say “if it works, don’t touch it”. The problem is, we have only seen how such tokenomics are firing during strong bull markets. An indication of what could possibly happen when a broader market correction unfolds is DEX tokens’ behavior during the short-lived dips recently seen.
On September 2, the crypto and capital markets took a sudden hit. Most DEX tokens lost between 10% to 20% of their market capitalization in a matter of hours, with some having up to 50% of their value being wiped by the end of the week. In order to answer the question of whether such price decline has been an overreaction (hence buying opportunity) and where the intrinsic value of such token falls, the next post will take a closer look at the Curve DAO Token (CRV) - its baked-in incentives, competitive position, and community.