In part 3, we covered how Lifinity utilizes voting to determine emission allocations and bribing to create an additional source of passive income for veLFNTY holders. In this article, we explain our DEX’s two sources of revenue and how they are used to reward veLFNTY holders and continue growing our protocol-owned liquidity (POL).
- Liquidity providers’ share of fees will be dynamically adjusted according to how close a pool is to its optimal level of liquidity
- In addition to trading fees, Lifinity profits from market making (buying low and selling high)
- Half of our revenue is distributed to veLFNTY holders, and the other half is used for LFNTY buybacks
Table of Contents
Lifinity is unlike other DEXs in that it is not constantly looking to maximize the amount of liquidity deposited on its platform. Assuming liquidity providers (LPs) earn a fixed share of fees (as is standard), there is a point beyond which additional liquidity decreases the trading fees earned per unit of liquidity. This is because there is only a fixed amount of trading volume to be shared among all the liquidity in the Solana ecosystem. When a pool is still small, additional liquidity will help capture a disproportionate share of trading volume. However, once a pool is sufficiently large, new deposits by LPs will only marginally increase the amount of volume, and this effect will be overshadowed by the dilution to the trading fees earned per LP token.
Normally, LPs are the only contributors of liquidity and the above dynamic is subject to self-regulating forces — LPs add liquidity until the yield becomes too low to motivate additional deposits, and the pool reaches an equilibrium. However, our pools also contain our POL. Therefore, we wish to mitigate excessive liquidity provision that reduces the profitability of veLFNTY holders. For this reason, we will incentivize deposits dynamically to optimize for protocol profitability. This will be done in two ways.
The first is to determine an approximate target liquidity where the trading fees earned per unit of liquidity is maximized. The target liquidity for each pool will be chosen by the team by looking at market data such as trading volume, average trade size, and the size of other protocols’ pools. The lower our current liquidity is compared to the target liquidity, the greater the share of trading fees that LPs receive.
The second is to more heavily incentivize LPs to deposit when we have less POL. This will help pools to bootstrap liquidity in their early stages, but as we acquire more POL, LPs will be gradually incentivized to withdraw their liquidity due to the lower share of trading fees they capture. This prevents the fees earned by the POL from being diluted unnecessarily.
We calculate the percentage of trading fees that LPs earn (ranging from 0% ~ 100%) based on the above two factors as follows:
LPs' share of fees = max(0, 1 — ((P+L)/T)^i),
- P = POL
- L = LP deposits
- T = Target liquidity
- i = Incentivization factor
All trading fees that do not go to LPs will be retained as a protocol fee.
For example, suppose the target liquidity is $1M, POL is $200k, LPs have deposited $300k, and we use an incentivization factor of 2. Then LPs will receive max(0, 1 – ((200,000+300,000)/1,000,000)²) = 75% of trading fees.
The aim of this model is to only slowly reduce LPs’ share of fees while we are far from the target liquidity to heavily incentivize deposits, but quickly reduce it as we near the target liquidity to signal that we are less in need. The speed at which the LPs’ share decreases is determined by the incentivization factor; increasing this number more heavily incentivizes LP deposits and vice versa.
We will start with an incentivization factor of 2 and closely monitor our pools to make sure the composition of liquidity smoothly transitions from mostly LP deposits to mostly POL and make adjustments if it fails to properly incentivize LPs.
Some readers may wonder why we let LPs’ share of fees go as low as 0%. This is to optimize the protocol’s profitability and to ensure that there is room for bribing. If we reach the target liquidity with just LP deposits but do not reduce the LPs’ share of fees, there will be no reason for other protocols to bribe (since there is already enough liquidity) and our POL will be less profitable since its share of earnings will be significantly diluted by LP deposits. Therefore, we handsomely reward LPs while we are reliant on them but gradually reduce those rewards as we become self-sufficient.
(Note: An exception to this system is the liquidity provided by Lifinity Flares (our NFTs). Their share of trading fees will always remain a fixed 85%, as originally stated in their introductory article.)
Rather than looking to attract LPs at any cost, we consider it a privilege to be an LP on our platform. It therefore comes with certain restrictions that ensure LPs don’t benefit at the expense of veLFNTY holders. Being an LP gives you temporary and partial access to our pools’ yields, while veLFNTY holders have permanent and full access through our POL. The reason we are able to employ this policy is the profit we generate from market making.
Market Making Profit
Lifinity is able to generate more yield compared to other AMMs (i.e. organic yield from trading activity, not unsustainable yield from inflationary token rewards). In fact, LPs can earn yield even if they receive no trading fees! This is possible because Lifinity profits not just from trading fees but also from market making — buying low and selling high. Lifinity can also experience impermanent loss (IL), which is essentially the opposite — buying high and selling low — but our tests and actual performance indicate that IL is the exception rather than the rule.
We have previously bundled these two aspects together and referred to them as “impermanent gain” to communicate that our DEX has the unique property of being able to profit from market making even as prices diverge. We will now be dropping this term and instead adopt the more accurate “market making profit” (MMP).
MMP is the total profit and loss from market making. Thus, IL is to constant product and Uniswap v3 style AMMs as MMP is to Lifinity. The difference is that while IL can never be positive (as the name implies), MMP can.
As with IL, MMP is measured by comparing the total value of a pool’s assets (excluding trading fees) to their value if they had not been traded and instead were just held. If the value of the pooled assets is greater than if we had just held them, it means MMP is positive and we made a profit by market making. On the other hand, if the value of the pooled assets is lower than if we had just held them, it means MMP is negative and we would have been better off just holding the pooled assets.
Lifinity will never take MMP from LPs. This means LPs have a sort of IL protection and indeed on average should expect to make money from market making rather than lose it as they would on a constant product or Uniswap v3 style AMM. Note that this is true even when the total liquidity is greater than the target liquidity and LPs receive 0% of trading fees; they can still earn yield from MMP.
On the other hand, when POL > target liquidity, Lifinity will treat its POL’s MMP as revenue if it is positive. In other words, profit will be taken as long as there is no IL. This ensures that pools never permanently shrink in size compared to if we had just held their assets rather than trading them, but also allows us to distribute more revenue to shareholders rather than growing our POL beyond the target liquidity.
Lifinity’s total revenue is the sum of protocol fees and the MMP that is withdrawn as profit.
Revenue will be in the form of LP tokens. We will use the two tokens within an LP token for different purposes, so it will be convenient to refer to them as the buyback token and the reward token.
In general, stablecoins will be the buyback token. During the first year, all buyback tokens will be used to buy back LFNTY, which will in turn be used to acquire more liquidity by selling it as veLFNTY. After the first year, 80% of buyback tokens will be used to buy back LFNTY and 20% will be used to fund ongoing development. This is to ensure that the development of Lifinity remains sustainable beyond the funds raised in the IDO.
Reward tokens will be distributed pro-rata to veLFNTY holders. For example, if we have SOL-USDC, BTC-USDC, and ETH-USDC pools, veLFNTY holders will receive SOL, BTC, and ETH as rewards.
The choice for buyback and reward tokens will vary for pools with no stablecoin or two stablecoins, but the overarching goal is to align ourselves with bribing protocols by avoiding creating sell pressure for their tokens. In addition, the structure outlined above eliminates the need to do any trading so that rewards aren’t reduced due to trading fees (in the case of buying back LFNTY, the fees accrue to our own LFNTY-USDC pool so there is no leakage).
All veLFNTY holders gain exposure to tokens that we have pools for as well as the tokens of bribing protocols, so bribing is a great way for protocols to expand their holder base. Viewed from the other side, holding veLFNTY is a great way to passively gain exposure to a wide variety of tokens in the Solana ecosystem, both from revenue and from bribes.
Lifinity’s DEX functions very differently from constant product AMMs and Uniswap v3 style protocols, and as a result the ways in which LPs are incentivized and the revenue is used are very different from what users have come to expect from a DEX. As a result, Lifinity is able to maximize shareholder value even while providing lucrative opportunities for LPs while they last.
In the next article, we will look at how the pieces we have laid out so far fit together to form a cohesive tokenomics for Lifinity and see how we compare to other protocols.