Farewell, the era of liquidity mining

Author: TapiocaDao

Time: 2022.10.20

Article Source:

Liquidity mining obituary

June 16, 2020 - October 19, 2022

Liquidity mining is a mechanism that incentivizes users to provide liquidity and earn reward tokens. TapiocaDAO officially announced the end of liquidity mining today. We provide a novel and brand-new DeFi monetary policy with the characteristics of sustainability, permanent value capture, and economic consistency of participants. The above characteristics are the "trilemma" problem encountered by the liquidity incentive mechanism, and TapiocaDAO solves this problem through DAO stock options (DSO). We invite you to read the yield farming obituary below, along with details about this disruptive mechanism.

Liquidity mining started on June 16, 2020, and was launched by the decentralized lending protocol Compound. Participants will be rewarded with COMP tokens whether they borrow or lend on the Compound protocol. These tokens are used to increase the rate of return for borrowers and subsidize interest rates for borrowers.

Compound’s “TVL” (total value locked) increased by 600% immediately after the launch of the liquidity mining program. However, this had an unexpected adverse effect on Compound's meteoric growth. A small percentage of the “miners” end up holding the COMP tokens they earn. According to the report, only 19% of accounts kept 1% of their acquired COMP tokens, dumping 99% into the market.

Second, the cost incurred by Compound in renting liquidity in the form of issuing & circulating new tokens usually results in huge operating losses compared to the income generated by renting liquidity. In this case, operating loss refers to the difference between the protocol's operating expenses (issued reward tokens) and revenue (fees). This huge operating loss is its main negative, besides the severe dilution faced by COMP token holders.

As the chart above shows, almost all DeFi projects have experienced huge losses. This is not because of insufficient income. DeFi protocols generate relatively high revenues. For example, AAVE's annualized revenue reached $101.4 million. The problem seems to stem from distributing 90% of its revenue to borrowers, leaving the protocol's profit margin at around 10% or around $10.92 million, but that's not the core issue. The protocol itself still has millions of dollars in revenue. The question is all about the role of liquidity mining. AAVE paid $74 million in liquidity incentive fees, making the largest DeFi protocol a net loss of $63.96 million. Does AAVE need to issue AAVE tokens to liquidity providers free of charge? No need, but that's the reality.

However, the only profitable project is Maker. It generated a total of $28.61 million in revenue, all of which went to the DAO. There are no reward tokens and dividends, and it proves that not every protocol needs tokens. In fact, many DeFi enthusiasts prefer protocols that do not provide tokens. No reward tokens, no operating losses, and no dilution. But it is undeniable that a well-designed and well-balanced token economy can indeed work wonders.

Some people may say: "These incentive programs attract liquidity, what's so bad about it?" "Liquidity is king". In fact, what attracts is not liquidity, but liquidity locusts; those non-loyal liquidity miners, they leave after taking rewards, transfer to the next exciting token project, or wait until the current project’s Rewards run out. Because these liquidity “locusts” use the single function that liquidity mining token rewards provide — governance rights, Compound is now unable to even turn off the liquidity mining spigot. This leads to a serious problem where there is a divide between financially committed participants and loyal token holders in a token economy. Loyal token holders actually contribute to the growth of the protocol, while liquidity miners want to reap benefits at any cost. They will vote to continue to pursue their best interests, and it's all our fault. We did not properly guide and design the token economy system, which led to this unbalanced situation. We should take responsibility for this problem and find solutions to restore the health of the token economy.

Compound is not the originator of the concept of "liquidity mining" (not even liquidity mining based on smart contracts). That honor should go to Synthetix's "StakingRewards" contract, which was co-written by 1inch's Anton. Like many things, "yield mining" is just an old idea with a new name. In the cryptocurrency space, the concept of liquidity mining can be traced back to 2018 with FCoin, a platform known for seriously dragging down the Ethereum network. In fact, FCoin is the first cryptocurrency product to offer a concept similar to the yield farming we all know, which they call “fee mining” (a bit of a bad name, right?).

The founder of FCoin is Zhang Jian, former CTO of Huobi. FCoin provides a large amount of token incentives to its traders, hoping that this liquidity will attract more users. FCoin is effectively betting that users will stay on the exchange after the liquidity incentive program ends. However, it is not. Users didn't stay.

A token model has a good liquidity incentive design, but also needs a sound monetary policy, including solving issues such as token supply (dilution), token demand, and token circulation. This is critical because it will affect token prices, which will affect the effectiveness of incentive programs, which in turn will affect how much liquidity the protocol can attract.

The current goal of liquidity mining is to rent liquidity. Let's ask a question: would you rather receive $1 million or $100,000? If you answer "of course it's $1 million", then you, like almost every DeFi protocol in existence, have not properly assessed the question. How long will you have the $1 million? Taking time into account reveals key details in properly assessing the true value offered. If the question had been changed to "Would you rather have $1 million for a second or $100,000 for a year," your answer would likely be different. In a second, you can do almost nothing, but in a year, you can do a lot; the same goes for agreements.

These “liquidity lease incentive programs” attract liquidity speculators, but are completely unsustainable and extremely limited in their core objectives. According to a Nansen study, “Up to 42% of yield mining participants exit within 24 hours of project launch. By the third day, 70% of participants have withdrawn from the contract and never returned Pass."

According to this data, liquidity speculators are entering these projects simply to maximize their returns, and the protocol is not creating any real long-term value other than negligible fee income compared to the cost of incentivizing liquidity negligible. In order to incentivize these liquidity mining participants, the protocol usually allocates most of the token supply to liquidity providers, because they have no loyalty to the protocol itself and only exist to grab profits. In other words, these token rewards are nothing more than mafia protection money, "As long as you keep paying me, your DefiLlama ranking will stay high, understand?" At the end of the day, the protocol actually owns the What? Nothing at all. Once the protocol stops paying rewards, liquidity drains quickly.

Whoever controls liquidity controls DeFi

Welcome to Olympus

Olympus revisited this fragmented model, instead of trying to create a model that pays for leased liquidity forever (obviously impossible), instead, they correctly recognize that a protocol should create permanent value for itself and increase its assets Balance Sheet. They took advantage of the demand for OHM tokens and created POL (Protocol Owned Liquidity). They are the first to realize that instead of negotiating with liquidity providers, you can beat them at their own game and create permanent value for the DAO's balance sheet through gamification, making the mafia think they are winning up.

Although some may say that Olympus is a failed experiment, Olympus was the first project to launch continuous payment for leased liquidity. POL has become an important mechanism in the "DeFi 2.0" field. So, why did Olympus ultimately “fail” when they were successful in identifying key monetary policy omissions in DeFi — the lack of real value creation? 3,3 The mechanism, like other liquidity mining projects, caused the OHM bubble to expand by providing unreasonably high returns. (Remember: if you don't know where the gain is coming from, then you are the gain).

Eventually, the economic inconsistency of the protocol participants reached a tipping point, and the liquidity miners who controlled the majority of the OHM supply felt they had extracted as much value as possible from it, and pulled out, sending the OHM price into a death spiral. Olympus panicked and offered a reverse bond. Reverse bonds allow users to sell their OHM tokens back to POL assets. This move resulted in the loss of OHM's POL (the only real value created), made fiscal reserves undiversified, and reduced investor confidence. And Redacted was the only winning player in Olympus because it quickly adjusted its strategy and kept POL once the dilution got too high.

However, even if Olympus "failed", it should not negate the significance of Olympus and POL.

Enter the ve era

ve, or "Voting Escrow", was pioneered by Curve and embodied in veCRV. Curve places great emphasis on protocol loyalty and requires liquidity rewards to be locked up so that potential liquidity providers can maximize their rate of return from the liquidity incentive program. Curve actually creates a tiered incentive structure: the more loyal you are to Curve, the more rewards you will earn.

Although the approach of taking loyalty (now loaned liquidity + time) into account greatly enhances Curve's ability to keep economic participants consistent and create more loyal protocol users. But the problem remains: Curve does not own liquidity; investors will still suffer from the dilution effect of token distribution, and liquidity providers can still get it at almost no cost (withdrawing the provided liquidity at any time) Valuable CRV. Imagine how much value Curve could have created with its POL that was being left on the table and captured by Tapioca if it wanted to.

When the value of CRV falls, the CRV incentives also become less valuable, so these token issuances also become less valuable. Protocols compete for veCRV in the Curve War, which creates an "incentive embedded" mechanism; Protocol X mints and circulates their tokens through an incentive plan to own veCRV and thereby control the incentives of CRV. It's a nice mechanic, but as a protocol all you're doing is diluting shareholders by minting new tokens for less liquid assets like veCRV. Add to that Redacted and Convex, and you have an internal mechanism of internal mechanisms. These features should have been built into Curve from the start. ve's inefficiency actually gave birth to an entire industry. You might attract more liquidity through the veCRV incentive than through your own token, why not focus on increasing the value of the incentive itself?

This is not to emphasize the criticism of Curve, because clearly ve is the best staking method ever, because it can achieve the alignment of economic interests of the participants. However, at the protocol level, the Curve wars are a bit illusory. As a protocol, why give up a valuable asset for an illiquid asset that may not have valuable incentives at any given time? In fact, similar to Yearn, Badger, and StakeDAO, the service of renting veCRV is actually more attractive-taking advantage of its intrinsic value while it exists. Attract liquidity through the "rented" veCRV, and trap this liquidity in the protocol as permanently as possible.

In the end, for Curve, the only way it can create permanent liquidity is to be part of the "mafia". Protocols need Curve to stabilize their stablecoin, not to earn fees. What if, instead of trying to lease more liquidity, own more liquidity directly with fees generated by Curve pools? That's exactly what Tapioca is doing. We've left the virtual world, taken the "red pill" and tried to own the only real thing in DeFi - liquidity. Or you can choose to take the "blue pill" and pretend to permanently incentivize liquidity by gamifying these mechanics more. I'll show you how deep the rabbit hole really is, Neo.

Enter Andre Cronje

Before Andre created Solidly Exchange and ve3,3 - two pioneering attempts to solve the persistent problems in ve liquidity mining, Andre created the OLM for the experimental automated network Keep3r Network - Options Liquidity Mining ( option liquidity mining).

Andre (in his usual way) started an initiative that would later revolutionize DeFi. If you provide liquidity to Curve and use CRV as your liquidity mining reward, what actually happens? A liquidity provider exercises a CRV call option with a strike price of $0 and no expiration date. When you start thinking of liquidity mining program issuance as an American call option, the protocol suddenly has power that it didn't have before.

The problem with Andre's OLM is that the protocol still doesn't create any POL (protocol capture liquidity). The conversion of options is the key to DSO. oKP3R distributes option redemption to vKP3R holders, which is a noble and simple way to incentivize staking. But we come back to a core question again: "Why do we provide liquidity incentives to our protocol?" The purpose is to generate sufficient liquidity depth to maintain the core functions of the protocol, but the purpose of these services is to generate income, in order to Maintain the operations of the entire organization. By holding your own liquidity, you no longer need to provide incentives for it. Choose to accept the red option "red pill" and exit the matrix world of liquidity mining.

Turn off the printing machine

The Synthetix Improvement Proposal SIP-276 by Kain Warwick addresses the severe inflation issues that have arisen in the DeFi Summer Protocol. These protocols heavily incentivize (rental) liquidity, and Synthetix wants to (as usual) be the first to stop further expansion of supply. It’s hard to argue that Synthetix has successfully kick-started its ecosystem when its revenue has even surpassed that of Ethereum at some point.

Turning off these rewards can be very difficult, as Compound sees it, because liquidity providers typically control governance. If the proposal is passed, as leased liquidity, the liquidity may leave the agreement immediately, and due to the reduced liquidity depth, the fee will drop, and it will be difficult to maintain the ecosystem in the future. While Tapioca will be on a similar path, Tapioca will strive to capture as much POL as possible during the projected inflation. Once the supply reaches a predetermined peak, the protocol will be maintained by its own POL. These POL fees and benefits will form a virtuous circle (acquire POL > generate revenue on POL > acquire more POL > repeat cycle). Tapioca will be able to discreetly inflate the supply of TAP to predetermined levels using American-style options that themselves create permanent value.