DeFi 102: Liquidity Pools and Liquidity Mining

By Michael @ CryptoEQ | CryptoEQ | 17 May 2024


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Intro

In the realm of DeFi, the overarching aim of incentive programs is to yield a net positive value for the underlying protocol. This is especially true for Automated Market Makers (AMMs), where the primary objective is to foster enduring growth in liquidity and market share. As the value of an AMM is closely tied to its utilization by Liquidity Providers (LPs) and traders, achieving sustained growth becomes pivotal for generating long-term positive returns.

However, the challenge lies in sustaining this growth beyond the span of the incentive programs. Historically, rapid expansion achieved through indiscriminate expenditure tends to be short-lived, often dissipating as soon as the incentive scheme concludes. While this transitory nature has characterized many AMM incentive programs, there is potential for a departure from this norm.

Navigating the Landscape of AMM Incentives

In the universe of AMM incentives, two distinct avenues emerge, each tailored to reward a specific cohort within the ecosystem. Trade Mining programs seek to entice traders by compensating them for their activity on the AMM platform. On the other hand, Liquidity Mining programs are designed to attract LPs, incentivizing them to provide liquidity to the platform.

Though some strategies may interweave elements of both Trade Mining and Liquidity Mining, it proves advantageous to examine these mechanisms in isolation for clarity's sake. The durability of incentive-driven growth rests on the post-program allegiance of traders and LPs. Discerning the factors that render trader or LP involvement self-sustaining becomes the bedrock upon which the design of impactful incentive programs is built.

Trade Mining Endeavors: An Exploration

Within the realm of Trade Mining, certain AMMs have experimented with directly compensating traders based on their trading volume. The objective is to onboard new traders who will continue utilizing the platform even after the incentives cease. However, this approach confronts significant challenges:

  • User Elasticity: Traders gravitate toward optimal trade execution, making it improbable for them to stick with an AMM that offers less competitive pricing compared to alternatives. This inherent dynamic undermines the lasting impact of Trade Mining beyond the incentive period.
  • Lack of Sybil Resistance: Substantial rewards may outweigh the cost of random trades, prompting users to artificially inflate their trading volume. Identifying and filtering out such behavior is imperative, lest the program's effectiveness wanes due to inefficiency.

Recent analysis reveals that the majority of traders on decentralized exchanges prioritize execution quality. This renders the rationale behind trade mining programs less compelling, as the absence of trader loyalty and the transient nature of growth cast doubts on their viability.

Furthermore, Trade Mining strategies are susceptible to exploitation and difficult to optimize. Theoretically, restricting rewards to a small portion of trade volume could alleviate friction without inducing inorganic trading. In practice, though, preventing reward farming that contributes no long-term value to the protocol proves intricate. As a result, Trade Mining hasn't gained widespread traction in AMM incentive designs, save for a few exceptions.

Liquidity Mining: A Pathway to Persistent Growth

Currently, Liquidity Mining stands as a dominant approach within DeFi for stimulating AMM expansion. The crux of this strategy entails incentivizing LPs based on their supplied liquidity and its duration or utilization on the protocol. Despite a mixed historical track record, Liquidity Mining presents untapped potential when approached with strategic foresight and analytical rigor.

Two mechanisms underpinning long-term, sustainable growth in Liquidity Mining programs emerge:

  • Forgetful LPs: LPs who inadvertently retain their liquidity post-incentive period or continue to provide liquidity for reasons unrelated to anticipated returns.
  • Liquidity Bootstrapping: This self-perpetuating cycle involves LPs attracting organic trading, thereby establishing a track record of robust volume and LP returns. This reputation then beckons further LP engagement beyond the incentive phase.

Contrary to conventional focus on forgetful LPs, Gauntlet's outlook favors liquidity bootstrapping as the prime mover. Observations suggest that LPs exhibit a degree of steadfastness, attributing this phenomenon to the liquidity bootstrapping mechanism.

Recent scrutiny of historical Liquidity Mining initiatives, specifically on Uniswap, indicates that judicious benchmarking renders these efforts more successful than initially perceived. As we all know, Uniswap dominates the decentralized exchange trading volume in the cryptocurrency space. Uniswap's success stems not only from its first-mover advantage but also from its superior efficiency. Uniswap boasts the largest liquidity pools with significant depth, resulting in minimal slippage for traders. This efficient utilization of capital attracts more trading volume.

The Flywheel: Users generate liquidity provider (LP) tokens and deposit them into the pool to earn trading fees. An increased number of LP providers leads to improved liquidity depth, reducing slippage for traders. Consequently, more trades are routed through these pools. As a result, the pool earns more trading fees, attracting additional users to participate and further enhancing the liquidity pool's depth and trading experience.

Liquidity Bootstrapping Pools

Overcoming liquidity constraints during an Initial DEX Offering (IDO) can be a formidable challenge, posing the question of the optimum price point for token launching. Liquidity Bootstrapping Pools (LBPs) present an elegant solution, negating the need for private financing rounds and reducing the volatility associated with smaller pools.

Instead of conventional practices fraught with the risk of mispriced launches, entrepreneurs can leverage LBPs to source initial liquidity and permit the market to determine the initial token price. This approach also mitigates risks associated with front-running and unwanted token dilution.

One popular mechanism to facilitate this innovative strategy is Copper Launch. It allows for the addition of initial liquidity at an elevated token price, gradually reducing as more participants contribute liquidity. Eventually, the price reaches an equilibrium, signaling the market's consensus on its worth. At this stage, the market price of the token is effectively approximated.

Once the market price is established, the pool is closed, permitting the reclaiming of funds and the distribution of tokens. Consequently, these funds can be employed to seed the pool, creating a platform for the trading community.

The merits of the proposed strategy include discovering a competitive market price for the token launch and providing early supporters the opportunity to invest at an advantageous price. However, a word of caution is needed. This strategy will invariably result in the initial distribution of some tokens, necessitating a token redemption mechanism to counteract the risk of front-running liquidity.

Implementing LBPs can result in a potentially sizable number of unvested tokens in circulation. To ensure that early buyers don't immediately liquidate their tokens, the parameters of the launch pool must be set judiciously. While this introduces an additional layer of complexity to the strategy, it provides a clever solution for the persistent challenge of determining the appropriate price point while raising funds.

Undeniably, the use of LBPs in the crypto landscape enhances the fundraising mechanism's efficiency and effectiveness, thereby promoting value creation in DeFi. Despite the inherent challenges, liquidity bootstrapping pools are a pioneering method for token pricing and fund-raising, as they address the needs of cryptocurrency investors and users with a high degree of precision and flexibility. The significance of this innovation lies not merely in its novelty but in its potential to reshape liquidity management in the rapidly evolving world of cryptocurrency.

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Michael @ CryptoEQ
Michael @ CryptoEQ

I am a Co-Founder and Lead Analyst at CryptoEQ. Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.


CryptoEQ
CryptoEQ

Gain the market insights you need to grow your cryptocurrency portfolio. Our team's supportive and interactive approach helps you refine your crypto investing and trading strategies.

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