On-Chain Liquidity — iZUMi Research

Foreword — About Liquidity

Author: iZUMi Research; @0xJamesXXX

Blockchain: A revolution in transaction systems + an explosion of liquidity

Blockchain can be used to mark value or represent various assets through freely circulating tokens, and by setting aside the restrictions imposed by some sovereign governments on centralized trading platforms, any individual can participate in a blockchain trading system with no barriers to entry through any device linked to the Internet.

AMM Automated Market Makers: The Birth of the DeFi Industry

In the whole blockchain trading system, liquidity can be said to be the transmission mechanism of the value of the pass. However, the traditional model of centralized exchange(CEX) has so far maintained the dominant position of “liquidity”. One of the reasons for this is that CEX is similar to the traditional financial trading system in that, in addition to the depth of trading provided by regular users with a genuine desire to trade, specialized market makers often play a more important role.


On-chain Liquidity

On-chain liquidity has experienced explosive growth in the past two years. Compared to off-chain liquidity on centralized exchanges, for one, the automated market maker mechanism has lowered the barrier to entry for the role of market liquidity provider, eliminating the need for specialized market making teams and centralized trading platforms, allowing any individual to provide liquidity to transactions while earning direct fee revenue.

“Farm” DeFi Summer — — DeFi 1.0

Yield Farming Token Incentive Model

In a broad sense, yield farming refers to DeFi users interacting with a protocol and being rewarded with native tokens from that protocol. A pioneer of this model is the DeFi lending protocol Compound, in which users who borrow or lend on the Compound protocol are rewarded with COMP tokens. The practice increases the revenue for the lender while subsidizing the borrower. After the launch of this program, Compound’s lending activity increased dramatically and the platform’s liquidity was enhanced substantially. In mere 20 days after Compound launched liquidity mining on June 16, 2020, Compound’s total locked-up value(TVL) increased from $180 million to $650 million, and the number of users quickly soared to 6,000.


Off-chain exchange liquidity mining

Liquidity mining on trading platforms did not actually start with DEX, but with one of the hottest projects of 2018, the FCoin centralized exchange. FCoin offers a significant platform token bonus to users who trade on its platform based on transaction volume, expecting the resulting liquidity to attract more natural users. It was to hope that users would stay after the liquidity incentive period ended. But it was never the case.

Limitations of on-chain liquidity mining 1.0

Similar to the fatal problems encountered with liquidity mining on FCoin, there are many limitations to on-chain liquidity mining.


DEX for Liquidity Efficiency — Liquidity Capital Efficiency of Underlying Transactions

On top of the most basic Uniswap V2’s x*y=K constant product AMM mechanism, numerous upgraded versions of the AMM mechanism have been derived. In this section, we will explore some of the most representative ones and analyze in depth how they break the liquidity trap mentioned above.

Curve: Stable Assets, ve-Tokenomics, and Convex

Curve protocol — a decentralized exchange based on Ethereum, focusing on trading of stable coins, pegged assets, etc. Compared to other DEXs, Curve offers more concentrated trading pairs with extremely low slippage and fees to meet the demand of a huge volume of stablecoin trading.


Uniswap V3’s centralized liquidity mechanism

High capital efficiency of Uniswap v3


Balancer — Programmable Trading Pool AMM

Balancer is also a DEX platform based on the Automated Market Maker AMM protocol, but unlike other DEXs, Balancer allows its trading pairs (pools) to consist of multiple tokens (2 to 8), each of which can initially have a different arbitrary share in the pool (2% to 98%). This is different from traditional AMM’s 50%+50% token pools (e.g. Uniswap) that rely on the x*y=k equation, as it allows for different and varying impermanent loss scenarios and capital efficiencies to be chosen depending on the specific token situation and the AMM pool usage scenario.

DODO — PMM Proactive Market Maker Mechanism

DODO is one of the more efficient DEX platforms in terms of capital utilization, mainly based on its innovative PMM (Proactive Market Maker) algorithm. At its core, the PMM algorithm is based on the introduction of an Oracle to obtain the current market price of tokens, mimicking the traditional market making behaviors, and introducing price parameters to adjust the AMM algorithm curve.


On-chain trading aggregator based on DeFi’s “Lego” attributes


Protocol’s improvement of liquidity model — top-level liquidity incentive guidance mechanism innovation

Innovations of DEXs provide better capital utilization efficiency for established liquidity funds and are used to adapt to various types of transaction scenarios. However, for other blockchain protocols, liquidity mining 1.0 has proven to be unable to efficiently and sustainably incentivize on-chain liquidity as the industry evolves. Therefore, to solve this problem, the DeFi industry has seen a lot of innovations in top-level liquidity incentive and guidance mechanisms, among which the most prominent and representative ones are Olympus Pro’s PCL mechanism, Tokemak’s liquidity bilateral reactors mechanism, iZUMi’s Uniswap V3-based LP NFT programmable liquidity mining mechanism, Ondo+FEI/FRAX’s collateral creation liquidity mechanism, and Solidly’s ve(3,3) model.

Olympus DAO — POL protocol Owned Liquidity + (3, 3)

In the previous perception of trading markets, liquidity is mainly provided by liquidity makers in the market. Whether they are professional market makers on centralized exchanges or liquidity providers on top of the DEX mechanism, they are relatively independent players in the trading environment. But Olympus DAO invented an alternative to the “liquidity mining” model using the Bond (bond) mechanism: it innovatively allows users to purchase platform tokens OHM at a discount from backed treasury assets or the associated LP token, continuously providing value to their treasury backing and mastering liquidity, thus creating a new concept of “Protocol Owned Liquidity (POL)”.


Tokemak — Decentralized liquidity market maker based on DAO to DAO model

Tokemak is designed to act as a decentralized market maker in the liquidity market. Through the unique mechanism of its platform, the traditional market-making behavior of market makers is replaced by the voting guidance of Toke token holders, and the funding source is extended to investors of various mainstream assets in the DeFi market as well as holders of corresponding project tokens and even other cooperative project DAO vaults. Through its unique see-saw dynamic yield feature, the platform can achieve a more efficient release of Toke tokens, thus helping liquidity demanders (project owners, DEX and token holders) to better manage and direct sustainable liquidity.


iZUMi Finance — Programmable Liquidity as a Service (PLaaS) based on Uniswap V3 LP NFT

In the previous section we analyzed the high capital efficiency of the Uniswap V3 centralized liquidity mechanism, and the high impermanent losses that accompany it. The solution to address the impermanent loss during DeFi 1.0 was also discussed in an earlier section, which was to issue liquidity mining rewards when users staking ERC-20 LP Token to incentivize more liquidity funding. However, in Uniswap V3’s centralized liquidity mechanism, the LP Token offered by Uniswap V3 has also shifted to the NFT model since the user can customize the value range of the liquidity offered and the liquidity offered by each user is unique.


Ondo Finance + FEI&FRAX — Liquidity as a Service (LaaS)

Ondo Finance is a decentralized investment platform that attracts capital by serving DeFi users with different investment products with fixed and floating returns.Fei Protocol and FRAX are both DeFi native stablecoin projects that rely on underlying assets to support their stablecoin value.The combination of Ondo and the other two creates a new liquidity provisioning model. This model can help protocols obtain sufficient liquidity for project tokens and stablecoin trading pairs at a very low cost in the early stages.


Solidly + ve(3,3) — — veTokenomics+Financial NFT+(3,3)+Ecosystem


Summary and outlook on the development of on-chain Liquidity


Hybrid trading model of DEX

In the development history of on-chain liquidity, AMM has become the main DEX trading model on-chain in order to accommodate the slow settlement time of blockchain. However, with the development of different chains, on-chain settlement time and cost will have a significant decrease, so the gradual introduction of traditional order book models or centralized professional market makers on the chain is becoming a reality. For example, 0x invented the RFQ quotation system, which has integrated real-time quotes from professional market makers into the trading aggregator to provide a better trading experience for on-chain trading users.

Cross-chain Composability

With the maturity of many public chain ecosystems, including the emergence of many Layer 2 solutions in the Ethereum ecosystem, the high gas fees of Ethereum have caused the DeFi industry, which is extremely focused on operational costs, to rapidly move to other different and lower cost blockchain ecosystems. Therefore, in the near future, cross-chain liquidity trading may become one of the daily operational processes in the DeFi industry, and DeFi platforms around cross-chain liquidity mining, Farming, and other functions are being developed accordingly.

Large Scale Applications of Financial NFT

Due to its uniqueness, NFT has been widely used for trading on-chain artworks, including “Everydays — The First 5000 Days”, which was auctioned for $69.3 million last year, as well as the avatar-based NFTs that have become a big hit this year: BAYC, CryptoPunks, Azuki, and so on. But NFT can be the credentials of many innovative financial products based on its unique token properties.

On-chain liquidity for more types of financial products + blockchaining of traditional financial markets

This is arguably one of the ultimate goals of the DeFi industry: to transplant the trading liquidity of various financial products in the traditional financial market to the on-chain environment, where the trading on-chain liquidity may even exceed the liquidity that exists in the traditional financial market, so that the on-chain trading environment will have the market pricing power of these financial products. Of course, there are many centralized institutions and regulatory barriers, but we are glad to see that more and more sovereign governments and financial institutions are taking a more positive attitude towards cryptocurrencies and the DeFi industry.


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iZUMi Finance: A Multi-chain DeFi Protocol Providing One-Stop Liquidity as a Service; Twitter:twitter.com/izumi_Finance; Discord: discord.gg/izumifinance

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iZUMi Finance

iZUMi Finance: A Multi-chain DeFi Protocol Providing One-Stop Liquidity as a Service; Twitter:twitter.com/izumi_Finance; Discord: discord.gg/izumifinance