AMM Incentivization: Velodrome and Aerodrome

Introduction

In the evolving world of decentralized finance (DeFi), Automated Market Makers (AMMs) have emerged as cornerstone protocols. Gauntlet’s “Intro to AMM Incentives” provides an overview of the incentive mechanisms that AMMs adopt to attract liquidity and trading volume. Building on that foundation, this article delves into the innovative incentive design used by Velodrome and Aerodrome Finance.

This article serves as a precursor of a more thorough analysis Vending Machine will publish, which looks into the relational dependencies of the Velodrome’s incentive mechanism to better analyse user interactions and network performance.

Section 1: Evolution of AMM Incentives

The landscape of AMM incentives has witnessed significant transformation since its inception. Initially designed to automate the market-making process, AMMs have grown in complexity and utility. Central to the AMM ecosystem are the liquidity providers (LPs). These LPs face challenges such as impermanent loss (IL) and loss versus rebalancing (LVR), but their role is pivotal to enable automated trading without a third party. They supply the liquidity that ensures seamless trades on decentralized exchanges. Incentives, whether it be trading fees or token incentives, are used in attracting and retaining these providers, ensuring that the market remains liquid and functional.

As discussed in the “Intro to AMM Incentives” article, the two fundamental incentive strategies to generate AMM activity are to target either LPs or traders. Incentivization of LPs has become the standard over time as trading incentives are easy to exploit without KYC and often fail to capture “sticky” users. Directly incentivizing LPs on the other hand, improves trade efficiency through the AMM (reduction of price impact) and tends to have a lasting impact on TVL after the program has ended.

Section 2: Velodrome and Aerodrome’s AMM Design

Velodrome Finance and more recently Aerodrome Finance have had success in the Optimism and Base ecosystems with their unique approach to AMMs. Whilst building upon the Solidly model, they incorporate components from Uniswap, Curve and Convex. Here’s a closer look at their design.

Key Features and Benefits

Velodrome and Aerodrome’s AMM design emphasizes flexibility and liquidity bootstrapping. It offers LPs token incentives while encouraging long-term users through its inclusion of a (3,3) inspired incentive layer.

The factory contract that allows users to create new liquidity pools includes two differentiations:

1. Stable Pools: these pools are designed for assets that should hold an equivalent price such as stable coins, wrapped assets and LSTs. It’s bonding curve follows a modified version of Curve’s stableswap pairs based on the x3y*y3x=k formula, allowing more efficient swaps of like assets within a standard price range.
2. Volatile Pools: these pools are designed for assets that fluctuate in price relative to one another. Its bonding curve is based off the Uniswap V2’s x*y=k bonding curve and allows for flexible pool rebalancing based on price fluctuations.

Differentiation

Unlike traditional AMMs, Velodrome’s and Aerodrome’s model incorporates mechanisms that address the challenges faced by new projects trying to launch a token. Protocols are able to create a liquidity pool for their asset and incentivize liquidity more effectively through ve-token gauge voting and providing bribes for other ve-voters to direct incentives to their liquidity pool, attracting liquidity whilst earning the trading fees resulting from trader activity for their assets. As long as the ratio between the cost of direct LP incentives vs the cost of incentives directed to LPs in the flywheel through bribes and ve-voters remains greater than 1, the system will be effective for protocols launching and incentivizing tokens.

Impact

For liquidity providers, there are a number of benefits. High token incentives, consistent compensation, and a more user-friendly interface make it an attractive option.

Section 3: Incentive Mechanisms

Velodrome’s and Aerodrome’s key differentiation in its offering comes from its token system architecture.

Incentive Mechanisms: Instead of directly rewarding LPs or traders with set incentives as outlined in Gauntlet’s article, they employ a liquid governance gauge voting model, where voters direct token incentives in exchange for 100% of the trading fees. This enables an ecosystem of perpetual incentives with emissions set on a programmatic distribution schedule directed by ‘vote locked’ governance tokens. LPs in this model earn the emitted governance tokens in replace of trading fees.

Bribes and veToken Gauge Voting: The features that solidify Velodrome and Aerodrome as a strong venue for seeding liquidity pools are the introduction of “bribes” and “vetoken gauge voting” natively to the AMM protocol. The gauge voting incentive distribution enables a more capital efficient option of incentivization for ecosystem participants and the bribe layer for vevoters further multiplies the effectiveness of incentivization for participants. Participant protocols are able to spend less capital for a greater effect of incentives by leveraging a 3rd asset (the vote locked tokens).

Section 4: Flywheel Sustainability

While the design offers numerous advantages for LPs and launch protocols in the short term, a closer inspection of the flywheel’s dynamics highlight potential considerations for sustainability.

The core premise of the flywheel is that with the use of emitted native tokens, it creates a marketplace for attracting and directing liquidity via locked tokens. Liquidity in this model is driven by how locked token holders vote; which is influenced largely by fee generation and bribes.

Fee generation

Emitted native tokens attract liquidity, liquidity creates better trade efficiency, better trade efficiency attracts more trade volume, trade volume accrues platform fees, fees increase the profitability for vote locking native tokens and directing emissions, which increases the demand for the native token, ultimately increasing the profitability for providing liquidity to that pool and perpetuating the flywheel.

The long-term effectiveness of the mechanism is directly related to its ability to accrue volume, and in turn fees.

Bribes

Projects use bribes to attract votes, locked token holders direct emissions to the project’s pool to earn bribes, the native emissions directed to that pool attracts liquidity, the protocol either continues to attract liquidity via bribes or via their own holding of locked tokens.

Bribes are a key feature for projects seeding liquidity in this mechanism. Velodrome’s and Aerodrome’s ability to attract projects looking to seed their first liquidity pool is related to the relationship between bribes and liquidity accrual. If for some reason bribes became less effective at attracting liquidity, ie — liquidity providers became less interested in the emitted native tokens as compensation for liquidity provision, the benefit for partner protocols participating in the flywheel would diminish.

Section 5: Future Developments

The Velodrome and Aerodrome teams are addressing these considerations by launching a clAMM. This launch, called slipstream, will improve trade volume efficiency; attracting more volume to their platform from the major pairs, and will stimulate token value by being able to earn these greater trading fees by locking and voting in the gauge with the token. In addition, they have announced an automated voting manager, called Relay, to help ve-token holders get the most out of their positions. Relay does this by incorporating an LP emission auto-compounder for liquidity providers to automatically accumulate voting power, thereby increasing the value of their rewards. It also introduces a fees and bribes auto-compounder for locked token holders to automatically convert their rewards.

Further Research

The incentive flywheel of Velodrome and Aerodrome is an exciting mechanism for liquidity bootstrapping and protocol token launches. To understand how the flywheel performs in practice, historical data should be examined. Namely, volume and fee generation, bribe effectiveness, locked token holder behaviour and liquidity accrual.

With the introduction of new features such as the clAMM Slipstream and Relay, the flywheel will change and feedback loops between variables will adjust. Monitoring and investigating these relationships should be conducted in order to adjust the system for optimal performance, ultimately saving the protocol and its users money.

Conclusion

Velodrome’s and Aerodrome’s novel approach to AMM incentivization is a testament to the continuous innovation in the space. Their design not only improves predictability of revenue for LPs but also directly caters for new protocols to launch and incentivise their pools effectively. In our next article, we will explore the incentive flywheel and the AMM design in more detail.