On-Chain Liquidity — iZUMi Research
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Foreword — About Liquidity
Author: iZUMi Research; @0xJamesXXX
In a traditional financial context, liquidity is defined very simply as the time scale of all that is needed for an asset to be bought or sold in the market at a reasonable price. Its importance in the entire economic and financial system cannot be overstated, and it can even be said that the modern financial trading system, and perhaps even the entire monetary system, is constantly evolving and innovating to better enhance the available liquidity for market transactions.
‘Cash’ or ‘Fiat’ money is generally considered to be the purest of liquid assets because it can be easily converted into other assets. Other financial products and tangible assets, such as stocks, bonds, art collections, real estate, and collectibles which tend to be the most common investments have declined at various points on the liquidity spectrum.
Thus we can say that highly liquid “currencies” are now the value transmission mechanism of the entire financial system and globalized trading system. The liquidity of a “currency” in the global trade market also often represents the position of the sovereign government that endorses it in international trade. The U.S. dollar, in this respect, deserves to be the most liquid “asset” at present.
The liquidity of money is commonly referred to as the ability to liquidate money quickly without losing it in circulation. However, in the digital era, the liquidity of “money” in the form of cash bills used in daily life is often less than that of “money” in bank accounts that exist digitally, and most of the financial products have been developed with the help of the Internet and electronic devices. The development of most financial products relying on the Internet and electronic devices has greatly improved the liquidity of transactions compared to paper bank notes, which we can call the “electronic revolution of liquidity”. The emergence and maturity of blockchain technology have brought the liquidity revolution to a new level.
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.
This revolutionary change solves the problem of barriers to entry for traders in traditional finance — bank or exchange accounts, trading qualifications, trading time limits, etc. are completely absent from the on-chain trading system.
The revolution of the on-chain transaction system, which brings a lower or even almost reduced to zero barriers of entry for users, means more full competition and more market efficiency in the microeconomic market mechanism that comes along with it. And in the blockchain marketplace, it means an explosion of liquidity.
Of course, it is also important to realize that the explosion of transaction liquidity in the broad sense here does not mean that the liquidity relied upon in every real transaction in the microscopic sense has been enhanced in direct depth. But again, this is something that the entire on-chain trading system, or the DeFi industry, has been refining and trying to address.
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.
Professional market makers can provide better transaction depth for exchanges while providing better token liquidity for partner projects, and a better trading experience for real users. This may seem like a win-win situation for all parties, but in an unregulated digital currency market without a market maker system, the relationship between the whole and the market maker is often not really conducive to the effective market discovery of the token price. Project parties, investment institutions, and even big token holders will also develop professional market maker teams to participate in market making in order to improve market liquidity, stability of token prices, and market value management.
However, in CEX, a large amount of trading data and counterparty information is not publicly transparent, so ordinary traders often assume the role of market maker profit source in disguise during the process of trading, and are also vulnerable to investment losses suffered by market value management.
However, the emergence of on-chain automated market maker(AMM) trading mechanisms, and the corresponding decentralized exchange platform and “liquidity providers”, provides a new perspective to solve part of the liquidity problem. Any independent individual can take on the role of a “market maker” to provide liquidity to the trading pair. Instead of relying on order book quotations to aggregate transactions with counterparties, trading users can trade directly with the pool through automatic algorithmic pricing and proportional token swaps.
The emergence of the AMM mechanism marks the beginning of the DeFi industry and also formally divides blockchain tokens liquidity into two parts: 1, CEX off-chain liquidity; and 2, on-chain liquidity.
Note: DeFi offers users a range of financial services to be completed through decentralized applications (Dapps) deployed on a blockchain smart contract platform without relying on a centralized institution. (Guosheng defi1)
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.
Also for traders, on-chain liquidity information is more transparent. Better on-chain liquidity also tends to give investors more information about their positions, as they can liquidate and operate more smoothly if necessary, without worrying about the huge price swings that tend to happen when liquidity dries up on centralized exchanges.
On the project side, better on-chain liquidity has always been their goal, and even according to the data, it can be found that the size of on-chain liquidity is often proportional to the market value of the project.
However, the most basic AMM automated market maker logic has a fatal flaw: while liquidity providers provide liquidity to the mainstream, heavily traded tokens and thus earn transaction fee revenue, they have no incentives on providing liquidity to some emerging tokens. This is because doing so means that they take the risk of Impermanent Losses, but only receive a very low transaction fee in return. They need to be financially justified to take this risk. This is what we often call the “chicken or the egg” problem: without sufficient liquidity, trading slippage will discourage users from participating in a DeFi protocol; without user participation in pass-through trading, there will be insufficient transaction fees and therefore insufficient financial incentives for third parties to build pools of capital and provide liquidity.
But the creative blockchain industry has also found a mechanism to solve this problem — liquidity mining（yield farming or LP farming）.
“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.
Uniswap, as one of the most mature AMM model decentralized exchange platforms at that time, users would receive a corresponding LP Token (Liquidity Provider Token) as a credential for the liquidity provided by the user, but the liquidity provider could only receive the fee incentive generated in the transaction in this model.
Inspired by the token incentive model of Compound, Sushiswap successfully launched a “vampire attack” on Uniswap’s liquidity by introducing SUSHI platform tokens and enabling the DEX liquidity mining model on top of the forked Uniswap platform code.
On the Sushiswap platform, users who provide liquidity to the pool are rewarded with a share of the transaction fees and SUSHI tokens, which also corresponds to the governance and revenue rights of the platform. If the user no longer provides liquidity, they can still earn a portion of the SUSHI protocol transaction fees with only SUSHI tokens. This better incentivizes the early liquidity providers, allowing them to continue to benefit from the long-term development of the platform, and ties the interests of both the “liquidity providers” and the “decentralized exchange platform” deeper.
In addition to the various DeFi platforms that enable liquidity mining to incentivize users to provide liquidity to their DeFi applications, the DEX + LP token mechanism also creates a new model for other blockchain project owners to rely on their tokens to incentivize on-chain liquidity for their corresponding transaction pairs. After providing liquidity for a project token to a mainstream pair on DEX, users can stake the acquired LP token and receive a liquidity mining reward from the project side.
This model is a good improvement to the fatal flaw of the AMM mechanism mentioned in the previous section: the initial small transaction volume generates fees that do not incentivize the liquidity provider to provide sufficient liquidity, resulting in a vicious cycle where users are less willing to choose on-chain transactions. However, by relying on liquidity mining, early liquidity providers can earn sufficient profit with the direct incentive of project tokens, and attract more on-chain funds to provide liquidity for the corresponding transaction pairs, and the transaction experience of on-chain users is optimized, thus turning into a positive cycle.
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.
Based on FCoin’s liquidity mining equation, traders can calculate the cost of trading (transaction fees) versus the revenue they can earn by selling mined tokens. A trading subsidy higher than the transaction fee means that swipe trading is profitable. As a result, FCoin’s trading volume had soared to $5.6 billion per day, making it appear to be one of the most liquid exchanges in the world. Nonetheless, it was obvious to most market observers that these volumes were fake and that buyers and sellers were simply mining through swipe transactions and selling FC (FCoin mining platform tokens) on the flip side.
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.
First of all, the most immediate purpose of any profitable economic activity that attracts funds is definitely to make a profit. So the pattern of most liquidity mining participants is very concisely summarized as “mine, withdraw, sell”. The industry also refers to this type of liquidity providers as “locust miners”. They do not provide long term liquidity for trading pairs or become long term holders of project tokens, but instead create a large sell order in the market, which does not help the market mechanism to arrive at reasonable pricing for the tokens.
Another problem is that liquidity mining campaigns that rely on token rewards are very costly and cannot be sustained over time. Since different liquidity mining activities exist simultaneously in the market, project teams often need to provide more tokens and higher APRs as incentives to attract liquidity providers, which greatly increases the cost of tokens for the project side, and such high incentives are not sustainable for a long time. The goal of full long-term liquidity cannot be achieved.
Also, the process of releasing a large amount of tokens to the market through liquidity mining as an incentive creates a lot of inflationary pressure on the project’s pass-through economic model for a short period of time, which is not in the interest of the project’s long-term development. Since the rules and released volume of liquidity mining are generally determined prior to the event, and the outcome of the event is often unpredictable, it is difficult for project teams to have a very clear liquidity target and successfully reach it.
So whether it is the DEX platform that introduces the AMM mechanism, or blockchain projects that carry out multiple types of liquidity mining, at this stage they all face the most fundamental question: how to improve the efficiency of capital, and how to better guide and manage liquidity?
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.
CFMM algorithm
This feature is largely due to Curve’s uniquely designed Stable Assets AMM model, which is based on a design concept that blends both constant sum and constant product market making models, combining the low slippage of a constant sum with the infinite liquidity of a constant product.
Therefore, compared to Uniswap V2’s constant product equation, trading pairs of stable coins and pegged assets traded on Curve platform can often achieve lower trading slippage based on fewer liquidity funds, which greatly improves the efficiency of liquidity funds utilization during the trading of stable assets.
ve-Tokenomics
In addition to innovations in AMM (Automated Market Maker) algorithm, another biggest innovation of Curve was the introduction of ve-Tokenomics. Curve introduced the “Vote-Escrowed” model in August 2020, allowing CRV token holders to lock their tokens for up to four years in exchange for veCRV (Vote-Escrowed CRV), and the number of veCRVs is proportional to the remaining lock time and veCRVs are set being not transferable or tradable in a smart contract. In terms of corresponding rights and interests, veCRV corresponds to the right to vote on a specific liquidity pool to get CRV rewards , and veCRV also represents Curve’s platform revenue right credentials, users can not only boost their own liquidity mining revenue through veCRV, but also directly get a share of Curve platform’s revenue.
Based on the circumstances, the option for liquidity providers to maximize their returns was to lock in CRV and get veCRV to boost their own liquidity mining returns and get more CRV rewards by voting to their preferred pools. The result is that the corresponding trading pairs get more liquidity providers and gain financial support, the trading pool increases and the slippage decreases, thus attracting more traders from the market to trade on Curve and reaching a positive cycle.
The most profound breakthrough is that Curve’s liquidity mining mechanism binds the interests of liquidity miners to the DEX platform itself for a long run. Curve’s TVL has increased gradually and is still the number one TVL in DeFi with $22.1 billion, providing a highly liquid platform for trading stable assets across the DeFi market with abundant liquidity funds.
With the proven success of the Curve platform, ve-Tokenomics is becoming an integral part of the tokenomics designed by many DeFi projects, such as Stargate, UDX, Curvance, Lendflare, etc. Multiple well-established DeFi protocols have launched or announced that they will integrate VE tokenomics models, including Ribbon Finance, Frax, Yearn, etc. On top of that, there are projects that combine VE models with NFT, including AC’s Solidly ve (3, 3) and iZUMi Finance’s DAO veNFT (veiZi).
Note: Both of these two products will be analyzed in subsequent sections of this report.
Convex — Creating liquidity for ve-tokenomics
One of the core mechanisms of ve-tokenomics launched by Curve is that the veCRV tokens obtained from locked positions are not transferable or tradable, so it has liquidity of almost zero. This is one of the most criticized mechanisms by the users, who constantly find themselves losing patience against the 4-year locked-up period They would not be able to gain benefits of veCRV to boost their own liquidity funds or compete for the right to incentivize CRV in the corresponding pool through veCRV voting.
To maximize liquidity for VE Tokens, Convex was born CRV holders can now pledge CRV on Convex and obtain cvxCRV. The Convex platform will automatically lock the obtained CRV tokens on Curve to obtain the protocol-owned veCRV tokens, so cvxCRV tokens can also be called liquid tokenized veCRV. After pledging cvxCRV tokens, users can obtain Curve governance rights, a partial $CRV liquidity mining bonus (10% of Convex’s total mining bonus), a 50% transaction fee ($3CRV), a Convex native token $CVX bonus, and an airdrop bonus from Convex.
Convex has also used this mechanism to obtain a large number of veCRV tokens, thus accumulating a very large amount of voting power over various liquidity pools on Curve. The competition for governance of veCRV among the Curve ecosystem, including Convex, is also known as the “Curve War” Data at current indicates that Convex has gained 43% of total veCRV and is dominating the war.
Bribery mechanism — Create Liquidity for the right of Governance
After the outcome of Curve War became obvious, the governance rights of Convex likewise attracted a lot of competition from users and other DeFi protocols. Users receive vICVX tokens after staking CVX on Convex, which likewise represents the governance rights and the voting rights of veCRV owned by the Convex protocol. In this aspect, whoever has more CVX and gets more vICVX, will have greater governance power over veCRV. This enables them to influence the volume, slippage, revenue, etc. of a certain stablecoin pool on Curve. Eventually, all protocols will realize the importance of CVX and vICVX governance rights. As they hoarded CVX tokens in large quantities, another more efficient mechanism to influence vICVX voting rights was created by the DeFi industry — a bribery mechanism for governance rights.
Votium Protocol builds an efficient governance rights liquidity platform for vlCVX’s bribery mechanism. vlCVX holders lend their voting rights on each proposal, thereby receiving bribe funds from buyers interested in accumulating voting rights. Buyers can easily set the total amount they are willing to pay for users to vote for their pools. And vlCVX holders can vote for their preferred incentive on Snapshot or delegate their vlCVX to Votium. Votium platform chooses the best incentive in each proposal, so that vlCVX delegates continually maximize bribe revenue from the Votium platform, and to date, Votium has also generated $157M in bribes for vlCVX holders, very efficiently unlocking the market value of governance rights, and creating a level of market liquidity for governance rights that did not previously exist.
For buyers or project owners looking to gain more liquidity on Curve with Convex governance voting, Votium provides a platform for efficient and low cost access to liquidity. They can use Votium to eliminate the cost of hoarding CVX tokens and the capital risk associated with price fluctuations, and instead gain direct access to the corresponding governance rights at a manageable cost, thus achieving their direct goal of attracting on-chain liquidity. For a $1 bribe provided by the current buyer at Votium, the LP will receive $1.53 in liquidity mining proceeds. Thus the bribe mechanism provides a lower-cost incentive model for protocols to compete for Curve and Convex’s liquidity mining revenue and thus incentivize on-chain liquidity for their own pairs, as opposed to directly providing funds for liquidity mining.
Uniswap V3’s centralized liquidity mechanism
High capital efficiency of Uniswap v3
Uniswap v3 has about 70% of the total market share of current on-chain trading in Ethereum, with 17 times the transaction volume of Curve at the same time. However, the TVL of Uniswap v3 is less than 1/3 of Curve’s. If we take the ratio of transaction volume to TVL as the capital efficiency of liquidity funds, Uniswap V3 platform has a capital efficiency that surpasses Curve by up to 50 times.
The core reason for such outstanding advantages lies in Uniswap V3’s innovative centralized liquidity mechanism. It increases customizable liquidity positions by allowing users to pool assets within a predefined price range. Users can treat a single V3 liquidity position as an AMM with x*y=k, but only for a set price range.
The term “offset” here refers to the function that sets the lower and upper price range limits in V3. As mentioned in previous content, this greatly increases the efficiency of funding assets in the liquidity pool, allowing users to customize their individual overall market making positions by holding different liquidity positions simultaneously. Thus, the concept of pooling liquidity around market prices replaces the concept of “unlimited” liquidity.
As shown in the chart above, the ETH/USDC pair is more volatile on the token price, and the liquidity is concentrated around the current price but relatively dispersed. The FRAX/USDC pair, on the other hand, is less volatile and liquidity is concentrated around 1 because it is both with stablecoins.
The other side of concentrated liquidity — Higher unearned losses
Topaz Blue and Bancor Protocol released <an in-depth study on Uniswap V3 earnings> in November 2021. The report provides statistics on fee income and impermanent losses. Surprisingly, according to the report, almost half of the liquidity providers (LPs) on Uniswap v3 experienced negative returns due to impermanent losses (ILs) during this period.
According to the data compiled in the report, 49.5% of the overall liquidity providers are in the red due to impermanent losses without any revenue. If we consider the liquidity providers as a whole, it is also in a loss-making position due to IL. Therefore, Uniswap V3 is currently not the best option for the average liquidity providers who expect high returns.
The only consistently profitable group of all liquidity providers is Flash LPs that offer only one block of liquidity, which came to be known as “Just-in-Time” (JIT) liquidity. However, due to the technical requirements to achieve JIT liquidity, there is no executional space for the average investors. Also, apart from this group of professional liquidity providers with the technical ability to execute Flash LPs, it is not possible to distinguish which group of people could benefit positively and consistently from the provision of liquidity on Uniswap V3 based on metrics such as the size of funds and the frequency of liquidity rebalancing.
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.
And the transaction fees for Balancer pools can be freely modified, ranging from 0.00001% to 10%, to fit in different trading scenarios. For example, pools charging a rate close to 0 can be used to support the special needs of high-frequency trading and improve the efficiency of capital utilization for corresponding operations.
Another model innovation of Balancer’s liquidity mechanism is the LBP for emerging token assets to guide liquidity. In the traditional AMM model, the emerging asset pool requires 50%+50% token ratio, so the model needs to deploy a large amount of funds from the founding team (50% of funds other than their own project tokens need to use mainstream tokens, such as ETH, USDT, etc.). Once the initial liquidity funds are not sufficient, it may lead to huge price fluctuations at the early stage of the launch, which is not conducive to reasonable value discovery. In LBP, the project side can dynamically change the short-term smart pool of token weights (e.g. 2%/98% ETH/$ tokens to 98%/2% ETH/$ tokens), thus allowing the project owner to create LBP with little capital and use it as a tool for token sales at the same time: in the process of token price sales, users can buy tokens from the pool at any time, but the token price will be under constant downward pressure during the process. When this is combined with moderate buying demand, the price remains stable throughout the sale process, reaching reasonable price discovery. This also eliminates the bot rush that tokens are prone to in other methods of token offerings.
Asset Manager
In the V2 product upgrade, Balancer introduced a new revolutionary concept, Asset Manager, to address the inefficient use of funds in the AMM pool. The Asset Manager will lend unused tokens to partner Aave’s lending Protocol through a smart contract, using the lending protocol to gain additional revenue, thus improving the efficiency of liquidity utilization and yield from a new dimension.
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.
The advantage of this over traditional AMM algorithms is that price discovery can be reached proactively and more liquidity funds can be concentrated around the current market price relying on a relatively flat price curve, thus reaching higher capital efficiency and also providing users with lower trading slippage and exposure to individual assets than traditional AMM protocols, and reducing impermanent losses for liquidity providers.
While the traditional AMM algorithm DEX can be called “inert liquidity”, the PMM algorithm and the centralized liquidity mechanism represented by DODO and Uniswap V3 represent the trend of “active liquidity” on DEX. At the Uniswap V3 level, the active adjustment of liquidity is achieved by the liquidity provider themselves, while DODO can automatically achieve the purpose of active adjustment of liquidity through the design of the algorithm, so as to achieve a more efficient liquidity capital efficiency.
On-chain trading aggregator based on DeFi’s “Lego” attributes
After introducing the innovative improvements in liquidity capital efficiency at the trading level by multiple DEX platforms, another major feature of the DeFi industry, the “Lego” attribute, also brings a new level of liquidity efficiency at the trading level, which is the on-chain trading aggregator built on numerous DEXs as well as the capital pool API.
This type of on-chain trade aggregator aggregates different liquidity sources together, allowing traders to trade effectively on different DeFi platforms at the same time. The aggregator also splits the user’s order into multiple parts and then executes them in a distributed manner across multiple DEXs or liquidity providers, automatically finding the optimal trade path for the user and achieving the goal of enhancing the trading user experience and reducing transaction costs.
The mainstream transaction aggregators in the market today are 1inch, Team 0x’s Matcha, Cowswap, and the transaction aggregator integrated within the Metamask wallet. Among them, 1inch dominates in terms of transaction volume, occupying more than 55% of the transaction aggregator market for a long time, while Metamask occupies half of the market share of aggregator users for a long time due to its large user base.
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)”.
POL — The Protocol becomes the direct master of liquidity
Bond purchases are the core mechanism of Olympus DAO’s POL, which allows users to purchase discounted OHM from the treasury via assets such as wETH and DAI, but requires a waiting period of 2 to 5 days to fully acquire the purchased OHM, similar to a short-term bond model. Users are motivated by the ability to purchase OHM tokens at below-market prices, thus continuously providing the treasury with various assets and obtaining OHM tokens.
In addition to treasury-backed assets, users can pay LP tokens in exchange for discounted OHM, typically LP tokens for liquid pairs associated with OHM, such as OHM-DAI LP, and LP tokens for stablecoins. The treasury can earn DEX transaction fees on these LP tokens, which ensures that the treasury can control most of the liquidity, and provides a long-term source of revenue for the protocol — the DEX transaction fee revenue. It turns the protocol itself into the primary liquidity provider in the market. Currently, Olympus DAO controls 99.52% of the OHM-DAI LP token market and has earned a cumulative $39M in DEX fees.
In addition to bond purchases, OHM token holders can pledge on the Olympus DAO platform, and its unique pledge mechanism combined with bond purchases becomes another unique mechanism for Olympus DAO in the DeFi space — the (3,3) tokenomic model.
(3, 3) Tokenomics — Innovation Or Scam?
Olympus DAO has attracted a large number of users in a short period of time thanks to its fomo-inspired (3,3) economic model, which is derived from the famous “Prisoner’s Dilemma” model in game theory.
After users acquire OHM through bond purchases, the Olympus DAO treasury is backed by valuable assets. In addition to the OHM tokens sold to users, the contract automatically generates OHM tokens, 10% of which are transferred to the DAO treasury and the other 90% are distributed to OHM stakers as Rebase rewards.
This resulted in a very high APY for OHM staking. Even in the first few months of the agreement’s existence, the APY for pledging OHM was tens of thousands of percent. This means that users can double their money in a matter of days by staking OHM. This creates a positive feedback loop that keeps the user motivated to keep buying OHM and staking OHM through bonds or DEX for a very high yield, and in the process the amount of treasury funds in Olympus DAO keeps increasing and the liquidity controlled by the agreement keeps increasing, thus creating a situation where the user and the agreement both benefit.
This situation corresponds to the (3,3) state in the upper left corner of the diagram above, when all users participate in the stake, it is a win-win situation for both users and the protocol, i.e. the (3,3) state. This is also the main reason why Olympus DAO is able to achieve a very high yield in the early stage of the Protocol’s development.
But the central problem with this mechanism is the unsustainability of the (3, 3) state: a higher APY also implies a higher premium, which will lead to a large amount of OHM as an incentive for inflationary output. At the same time, users will sell OHM tokens in the market in order to gain cash, and the price of OHM and the staking APY of the agreement will decrease until there is a panic sale by most users, which is the worst case (-3,-3) in the bottom right corner of the diagram, which is a corresponding loss for both Olympus DAO and users.
Olympus Pro — A Bond Market for DeFi Protocols to Get Their Own Liquidity
Based on Olympus DAO’s bond buying model, Olympus has launched Olympus Pro, a bond marketplace that enables other DeFi projects to access Protocol Owned Liquidity, allowing other protocols to borrow the Bonding feature of the Olympus platform and sell bonds belonging to their own projects, thereby gaining permanent liquidity under the direct control of their own protocols and earning DEX transaction fees, without having to provide highly incentivized liquidity mining activities to “rent” unsustainable liquidity.
Long-term holders do not need to speculate on price action in order to get more tokens. With bonds, they can offer LP tokens to the protocol in exchange for their original tokens at a discount. This is a win-win situation for both the token holders and the protocol itself.
As more liquidity builds up, the pool can support larger trades and ensure price stability and prevent large liquidity exits. This, in turn, creates a healthy liquidity mechanism that attracts long-term holders.
At the same time, the community is assured that liquidity will permanently reside in the protocol and users will always have sufficient liquidity to trade their tokens. Thus, users can accumulate confidence in the project’s development, which directly drives the project’s successful operation.
Olympus Pro has currently developed 19 partners to issue bonds on its platform and has accumulated $86M in liquidity for these projects.
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.
Tokemak’s Liquidity Funding Container — Reactor
Unlike traditional liquidity providers who need to provide trading pairs of two tokens, LPs in the Tokemak platform only need to deposit specific single assets in the corresponding token reactors. These assets will be invested in different DEX platforms through Tokemak’s unique decentralized liquidity steering mechanism to provide liquidity and earn revenue, while LPs will receive dynamically adjusted %APR in the form of TOKE.
Tokemak has two types of reactors. The first is the Pair Reactors, which are liquidity containers for mainstream assets and currently support ETH and 9 stablecoin assets such as FRAX, USDC, etc. After LPs invest these mainstream assets into the Pair Reactors, the funds will be used to match with the assets in the Token Reactors and then placed into the corresponding trading pairs on DEX to provide liquidity.
Each asset requiring liquidity on Tokemak has its own Token Reactor, and the liquidity provider invests the corresponding tokens into Token Reactors to earn TOKE revenue. There are currently 8 Token Reactors in operation, corresponding to 8 crypto assets.
On the other side of the bilateral reactor is the TOKE voting rights staked by the Liquidity Directors (LD). By staking TOKE to gain voting rights in the corresponding asset reactor, LDs direct the crypto assets in the reactor to the DEX trading platform of their choice to gain the benefits of liquidity provision. The DEX platforms currently supported by Tokemak are Curve, Uniswap V2, SushiSwap, Balancer V2. 0x trading platform will soon be supported in accord to the plan
Based on the Reactor mechanism, Tokemak has also designed mechanisms to improve the efficiency of capital and protect the returns of liquidity providers, such as its no-IL protection mechanism backed by a reserve pool and LD collateral, as well as tAssets that liquidity providers receive upon depositing assets. tTokens are received by liquidity providers when they deposit tokens into the reactor (e.g., tSUSHI tokens are received for depositing SUSHI).
These tToken represent the credentials of the token reactor assets deposited by the liquidity provider and can be redeemed at any time at a 1:1 ratio. tToken is also transferable and the owner can request to redeem the corresponding assets in the pool or participate in other tToken usage scenarios designed by the project, such as using the tToken staking mechanism to replace the traditional token staking mechanism and provides lasting on-chain liquidity with Tokemak .
The Dynamic yield balancing mechanism
Unlike Curve-like DeFi platforms, which require community voting to determine the incentive strength of different pools of capital, Tokemak’s platform automatically adjusts the yield between LPs and LDs through a dynamic balancing mechanism of reactor bilateral assets, thus efficiently balancing the amount of bilateral asset collateral.
If there are a large number of assets deposited in a given Reactor and there are fewer TOKEs to direct that liquidity, the APR is increased on the LD side of the Reactor, encouraging the LD to deposit more TOKEs and participate in directing that liquidity. Vice versa — if there is a large amount of TOKE staked in the Reactor and at the same time fewer liquid assets are deposited, the Reactor increases the APR to incentivize further liquid asset deposits.
Under this mechanism, liquidity demanders such as DEX and project teams of counterpart assets can attract liquidity for themselves in a new form on the Tokemak platform, instead of the traditional direct liquidity mining incentives provided to attract short term liquidity support. With Tokemak, liquidity demanders can stake more TOKE tokens on the right side of the corresponding asset, while the dynamic yield balancing mechanism automatically increases the yield of the liquid asset on the left side, thus attracting more liquidity funding from the market. At the same time, TOKE token stakers can also vote for supporting DEX to achieve the purpose of directing liquidity according to their needs.
Based on this mechanism, LP and LD will receive TOKE revenue that is not bound to liquidity gains on DEX, but simply backed by Tokemak’s own dynamic balancing mechanism and TOKE tokens. This breaks the traditional market maker revenue model and allows the Tokemak platform to store and accumulate liquidity gains as Protocol Controlled Assets (PCA).
According to the design of Tokemak, the singularity moment will be reached when PCA accumulates to a certain volume: Tokemak no longer needs to attract external funds to invest in DEX for liquidity mining proceeds and can directly use the PCA accumulated by the DAO treasury. The release of TOKE tokens will also stop at that time. And in traditional blockchain projects, most protocol treasuries are “valuable” only in the sense that their own tokens have market value. But if that token is sold off, the treasury becomes worthless as well. As the singularity approaches and is realized, the Tokemak protocol treasury value will consist of non-TOKE assets, effectively making TOKE an index of the various assets it backs.
TOKE’s value comes from the inherited value of the protocol-controlled assets it represents, as well as its value as a super-powerful governance token that allows TOKE stakers to direct liquid assets owned by the entire platform.
Collaboration Model in Web 3.0 Era — DAO TO DAO
Tokemak will use a community voting mechanism to determine which new token reactors will be built in the next phase. In the C.o.R.E.2. DAO governance ended in 2021, five new projects won the community vote, and the Tokemak team began work on the corresponding token reactors.
Before Tokemak builds a new token reactor, Tokemak team will dock with the corresponding project team or DAO, propose a corresponding DAO to DAO token swap proposal, and use the reserve TOKE tokens to swap the corresponding token assets as the reactor reserve pool. Such a cooperation mechanism is also more in line with the development trend of web 3.0 era — more project decisions will be decided by DAO decentralized governance. Thus the direct cooperation between two projects is also a direct communication and cooperation from DAO to DAO.
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.
This shift in the LP Token model makes traditional liquidity mining models impossible on Uniswap V3. However, to solve this problem, iZUMi Finance has launched the LiquidBox platform, which enables users to participate in liquidity mining activities by staking Uniswap V3 LP NFT to receive token rewards.
Based on the different needs of different project owners for the fluctuation of the token price and combined with the characteristics of Uniswap V3 LP NFT, iZUMi has launched three different types of programmable liquidity mining models on the LiquidBox platform to serve the liquidity needs of different scenarios.
“Fixed-range “ model — A centralized fixed range of reward prices for stablecoins and pegged assets
Fixed price range liquidity mining model for stablecoins and pegged assets with little price volatility, supporting projects and platforms to customize the range. Users can provide liquidity into the corresponding price range and stake the obtained Uniswap V3 NFT on the iZUMi platform to get transaction fee and a reward of iZi platform tokens.
Such a model not only accommodates the need for concentrated liquidity for price-stable assets, but also allows Uniswap V3 to directly benchmark Curve’s CFMM algorithm + CRV token incentive model with the support of liquidity mining on the iZUMi platform. The original Uniswap V3 liquidity provider will also receive an additional liquidity mining bonus in addition to the transaction fees.
Currently iZUMi supports Uniswap V3 liquidity mining on this model for USDC/USDT pairs on Ether, Polygon and Arbitrum. 87% of the $4.7M liquidity funds of the Uniswap V3@Polygon USDC/USDT pair are involved in iZUMi liquidity mining ($4.1M).Also in the Uniswap V3@Arbitrum USDC/USDT liquidity pool, the $13.3M TVL in the iZUMi platform accounts for 95% of the total pool ($13.95M).
iZUMi’s Fixed Range model provides liquidity providers of stable assets with a better option outside of Curve, and also helps Uniswap V3 to attract sufficient liquidity funds after the different L2 eco-launches, which will have a constant impact on the core business of Curve platform.
“One-Sided” Model — Unilateral Liquidity Provision and Impermanent Loss Risk Reduction
In the traditional AMM model, users need to provide two assets at the bilateral side of the current price in order to achieve the purpose of providing liquidity. But iZUMi’s LiquidBox platform proposes a new liquidity provision model: provide liquidity of mainstream assets such as ETH, USDT, etc. in the value range down from the current price, and another part of the project tokens are directly Stake in LiquidBox without participating in the liquidity provision of Uniswap V3.
This model of 50% liquidity provision + 50% Staking is more of a revolution to the traditional Staking model. In the traditional Staking model, many project users simply stake project tokens into the pool to receive mining rewards. However, this part of Staking users do not make continuous and substantial contributions to the development of the project, but are rewarded for inflation based on the economic model of the tokens held, so it is a very capital-inefficient way to reward community members.
However, during Izumi’s liquidity mining process, users participate in Staking with project tokens and receive rewards, but must match mainstream tokens of the same value as liquidity support to the liquidity pool of the corresponding trading pair in Uniswap V3.
When the price rises, there is no impermanent loss and the liquidity provider receives their reward from the Staking pool. When the price falls, the liquidity provider has the same percentage of impermanent losses as in traditional AMM. But in this case, the liquidity provider will not only receive transaction fees from Uniswap V3, but also the Staking bonus.
This provides a more efficient liquidity mining scheme that is in the best interest of both projects and token holders: in an up cycle, the liquidity of passively forming sell orders is lower, mitigating resistance to higher token prices; while in a down cycle, the potential buy orders provided by mainstream assets are not conducive to price declines.
“Dynamic Range” — Provide concentrated liquidity for the range around the current price
The user participates in liquidity mining by setting the current price (Pc) in the (0.25Pc, 4Pc) value range of liquidity. The width of the price range can also be predetermined by the project team, for example to (0.5Pc, 2Pc), which also provides a more concentrated liquidity. After a user provides liquidity to the pair through the iZUMi platform at the set price range, the iZUMi smart contract will automatically pledge Uniswap V3 LP NFT to the liquidity mining activity and the liquidity provider will automatically participate in the mining and start receiving the liquidity mining rewards provided by iZUMi and the corresponding project.
In addition to this, LPs will also receive transaction fee revenue from Uniswap V3, as the range of values set by the liquidity provider includes the current token price. The combination of these two revenues will significantly increase the liquidity provider’s expected returns.
The benefits of a liquidity provider’s participation in liquidity mining will be based on the thickness of the liquidity provided (v_liquidity) and calculated as a percentage of the program’s total liquidity.
Based on the iZUMi “Dynamic Range” model, setting the price range to (0.5Pc, 2Pc) provides approximately three times more efficient use of capital compared to traditional full-range liquidity mining activities.
veiZi — NFT governance + equity tokens combined with ve-Tokenomics
iZUMi officially launched the veiZi NFT tokenomics model combining community governance rights + platform revenue rights in February 2022. Inspired by the ve(3,3) NFT proposed by Andre Cronje, it also packaged its own ve tokens into the ERC-721 standard NFT. Users can obtain the corresponding veiZi DAO NFT by locking their iZi tokens.
Compared with Curve’s veCRV non-tradable and non-transferable model, the NFT form of veiZi comes with its own liquidity properties, and users can directly trade on veiZi through NFT trading platforms such as Opensea.
The same rule as veTokenomics is that the number of veiZi corresponding within the veiZi NFT will keep decreasing as the unlocking time approaches, and the user’s corresponding DAO governance rights and income rights will also keep decreasing, thus achieving the purpose of incentivizing users to extend the locking time and reach a deep interest binding with the longer-term development of the platform.
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.
Ondo’s native investment products
Ondo Finance has designed two different investment options for investors with different risk appetites: fixed income and floating income. Ondo will use the two types of token assets raised to provide liquidity on DEX to generate capital income.
Just like the waterfall hierarchy in traditional finance, the fixed income investment program will have the rate of return determined in advance by the Ondo team. Upon maturity of the investment program, Ondo will liquidate the entire proceeds, and the proceeds earned will be distributed to the fixed income investors first to guarantee the promised rate of return, after which all remaining proceeds will belong to the floating income investors.
Due to the uncertainty of the market, investors who subscribe to the floating return investment option are equally exposed to the possibility of loss while potentially earning excess returns. This uncertainty in returns also limits the growth of the Ondo investment platform.
LaaS model in partnership with stablecoin projects
FEI and FRAX, as DeFi’s very mature native stablecoin projects, have been able to maintain a stable exchange price close to 1:1 with mainstream stablecoins such as USDT and USDC, so many protocols have also made it one of their important goals to provide more sufficient liquidity for their project tokens to trade with FEI & FRAX stablecoin pairs. Therefore FEI & FRAX also play a very important position in the on-chain liquidity market.
Both project parties have partnered with Ondo and integrated directly with Ondo’s liquidity vault to reach a new liquidity model of providing LaaS to other projects. Projects in need of liquidity can deposit their native tokens into the Ondo liquidity vault, and FEI and FRAX will directly pair them with new stablecoins minted at the initial price of the tokens. These native tokens and stablecoins are then sent to DEX for liquidity provision. Since the other half of the liquidity position is provided, FEI and FRAX will charge a small fixed fee when the vault expires. Since the projects themselves act as liquidity providers, they will receive the transaction fees earned in the DEX, but also face a potential impermanent loss. At the end of the term, Ondo returns the liquidity provided in tokens minus transaction fees (positive) and IL (negative).
This unique LaaS model also provides a new liquidity access model for emerging project to obtain initial liquidity pairs on demand at a very low cost, without having to rely on themselves or attract liquidity providers in the market to obtain sufficient liquidity on DEX.
To date (March 31, 2022), Ondo’s LaaS model has successfully served 12 projects, providing a total of $119,526,784 worth of liquidity at a fee cost of 2–3% of total liquidity.
Solidly + ve（3，3） — — veTokenomics+Financial NFT+（3，3）+Ecosystem
Yearn Finance’s founder AC (Andre Cronje) launched a new project based on the Fantom chain called Solidly Exchange in January 2022. The launch of Solidly created a lot of buzz in the DeFi industry and brought a lot of on-chain assets to the Fantom chain. But what we didn’t expect was that less than a month after the launch of Solidly, AC announced its exit from the DeFi industry, followed by a massive token crash in Solidly and the Fantom ecosystem.
But Solidly has a number of innovations in his product: he has created an innovative design of the ve(3,3) token model by combining Curve’s ve model and Olympus’ (3,3) gaming concept with NFT’s token tool.
Aggressive inflation model to encourage lock-in, (3, 3)
In order to encourage locking and voting, Solidly will compensate users for the inflation risk associated with locking their positions and give lockers additional shares of tokens according to the total circulating shares to ensure that the corresponding equity shares of veToken are not diluted. In this way, users with locked positions will not have to worry about inflation affecting the total value of tokens in their accounts, while users without locked positions will have to bear the downside risk of the token price due to token inflation.
ve token upgrade to NFT
Solidly has two types of tokens, one is the ERC-20 standard homogenization token SOLID, which is also the platform token that users can trade directly on the exchange. The other is ve(3,3) in the form of NFT. Users need to lock the SOLID token to get ve(3,3) NFT and enjoy the various rights and interests corresponding to ve(3,3). Compared with the non-transferable feature of ve-CRV, ve tokens in the form of NFT add another form of liquidity property, and users can directly trade ve(3,3) NFT to transfer the corresponding platform rights and interests. An account can also have multiple ve(3,3) NFTs at the same time, which is convenient for users to manage.
ve(3,3) ouroboros self-perfecting loop
Unlike ve-CRV, Solidly lockers are only rewarded with token emissions from the pool they vote in and a share of the fees, rather than a share of the fees for all pairs traded on the entire platform, as on Curve. As a result, lockers are incentivized to vote and tend to vote for pairs with higher fee returns. This is to help the protocol automatically identify the best pools to pay rewards, i.e. pools with more fees have higher trading volume and better depth, which also generates more trading fee revenue for the Solidly protocol. This is designed conceptually in the future to enable the system to reach a closed-loop state in a positive cycle, constantly improving itself within the system, so that trading users, liquidity providers, SOLID token lockers and the Solidly platform itself benefit together in the closed loop. However, due to the impact of AC’s exit, Solidly did not succeed in realizing this design concept.
Summary and outlook on the development of on-chain Liquidity
If we count from Compound’s liquidity mining activities, the TVL of the entire DeFi industry has grown approximately 300 times in less than two years. Standing at this point in time, when reviewing the entire history of on-chain liquidity development, it can be found that the entire DeFi industry has grown much faster than the traditional financial industry in terms of iterations.
The maturity of Ethereum and smart contract Dapps set up the underlying technical platform for the emergence of the DeFi industry. On top of that, a series of mature DeFi applications and innovative mechanisms emerged in 2020: MakerDAO’s over-collateralized generation of stable coins, Uniswap V2’s AMM DEX, Compound lending platform’s yield farming, etc. These marked the arrival of the DeFi 1.0 era.
In its wake, a variety of innovative DeFi 2.0 projects have emerged to address the twin issues of how to improve the capital efficiency of on-chain liquidity and how to better channel and manage it. The former two chapters of this report also detail some of these representative projects.
With such a rapid iteration rate of development, one cannot help but have great expectations for the future development of the DeFi industry. Here will briefly describe a few of the possible major future trends in the DeFi industry, which would hopefully inspire you.
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.
Some of the examples are the Uniswap V3 LP NFT and the veNFT governance token launched by iZUMi and Solidly, and the Solv Vouchers Financial NFT launched by Solv Protocol, which represents a locked-in share of cryptocurrency. The exploration of Financial NFT in different usage scenarios will continue to increase, injecting new energy into the DeFi industry.
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.
Let’s conclude this report with a quote from the keynote speech by John Glen, Economic Secretary to the Treasury, about the UK cryptocurrency market on April 4, 2022:
“It’s not going to happen overnight… much though I appreciate many of you will want it to. But we will get there as quickly as we reasonably and responsibly can.
We’re on the cusp of something important.
We have the opportunity to shape and lead it.
And that is what we’ll do.”
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