What is Protocol owned liquidity? A Primer on the model developed by Olympus DAO

An introduction to a new method of providing liquidity to tokens on decentralised exchanges

Andrew Nardez
Coinmonks
Published in
8 min readDec 27, 2021
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Decentralised finance — known as DeFi — has seen explosive growth since 2020, bringing with it the potential to disrupt traditional finance.

In particular, the rise of decentralised exchanges (DEXs) — most notably Uniswap — introduced key innovations that allowed trading to be facilitated without a centralised intermediary, utilising an Automated Market Maker (AMM), liquidity pools and liquidity providers.

However, these innovations are not without their drawbacks. Namely, the mercenary liquidity problem plagues protocols, who often need to incentivise liquidity providers with substantial rewards to provide liquidity to enable trading of their token.

In this backdrop, a new form of providing liquidity to tokens on DEXs emerged in the form of protocol owned liquidity. This model developed by Olympus DAO, promises not only to resolve the mercenary liquidity problem, but also to create a reserve currency in the process.

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Summary

Protocol owned liquidity is new approach pioneered by Olympus DAO to provide liquidity to tokens on decentralised exchanges. Instead of relying on providing incentives to the market to provide liquidity to liquidity pools, the protocol owned liquidity model instead utilises a “bonding” mechanism. Bonding essentially involves the protocol selling their tokens at a discount to buyers, who in exchange will provide another token (e.g., DAI), which forms part of the protocol’s treasury. The treasury can then be deployed to provide liquidity directly to DEXs (earning trading fees) and can be invested to generate returns.

Protocol owned liquidity is an innovative solution to the mercenary capital problem, whereby protocols engage in a so-called “race to the bottom” to provide higher and higher incentives to attract liquidity providers, in-turn diluting the value of the protocols through the high issuance of tokens.

Protocol owned liquidity is likely to be an ongoing feature of the DeFi landscape, with protocols utilising a mix of the protocol owned liquidity model and traditional liquidity pools for trading on DEXs.

Context: Automated Market Makers, Liquidity Pools and Liquidity Providers

Automated Market Markers are an integral component in the functioning of DEXs. In contrast to centralised exchanges whereby buyers and sellers are matched through an order book, buyers and sellers in DEXs instead are trading with a smart contract (aka the AMM). The smart contract holds tokens to fulfill orders, with the price being determined by an algorithm (generally with the larger the volume of the order, the greater the price impact). Let’s run through a brief example to illustrate this.

Source: Uniswap

In the above graphic let’s assume that Token A is Ether (ETH), and Token B is OHM (Olympus DAO’s governance token). If trader A wants to purchase 1 OHM token, they would sell 10 ETH (noting that on DEXs tokens are traded against other tokens, not with fiat currency).

However, when trader A puts in their buy order for 1 OHM token, they are not actually transacting with another trader (as is the case in centralised exchanges). Instead, they are transacting with the AMM, who is holding in reserve 100 ETH and 10 OHM to facilitate trades. These reserves are known as liquidity pools.

However, this begs the question, how do the reserves get into the liquidity pools in the first place? Enter liquidity providers.

Liquidity providers are holders of a pair of tokens, who agree to “lock” these tokens in the liquidity pools. In the above graphic, the liquidity provider has provided 10 ETH and 1 OHM into the liquidity pool, and in return received a liquidity pool share (representing their respective ownership of the pool).

Liquidity providers are incentivised to lock their tokens into the liquidity pool by:

  1. Receiving a portion of the transaction fees paid by traders for each trade (0.03% in the above graphic)
  2. Protocols offering their own tokens as a reward

Attracting and retaining liquidity providers is essential for tokens listed on DEXs, as low liquidity on DEXs can result in huge price swings in the value of the token when there are insufficient tokens held in the liquidity pool to absorb trades.

Problem: Mercenary liquidity

Protocols face substantial difficulties in both attracting liquidity to their token’s liquidity pool and retaining liquidity. The cause of this is twofold:

  1. Transaction fees alone are often insufficient to incentivise liquidity providers to lock liquidity, resulting in protocols having to offer their own tokens as a reward
  2. Liquidity providers can easily move liquidity to different liquidity pools

The net result of this is that protocols may have to engage in a so called “race to the bottom” to offer more and more of their own tokens as a reward in order to attract and retain liquidity providers for their tokens liquidity pool. If not, liquidity providers (like mercenaries), will move their liquidity to other liquidity pools where they can get a higher return. This can result in protocols having to issue a large amount of their tokens as rewards, which dilutes existing holders and can put downward pressure on the price (particularly if liquidity providers immediately sell the reward tokens on-market).

Solution: Protocol Owned Liquidity

A potential solution to the mercenary liquidity problem comes in the form of protocol owned liquidity, a model pioneered by Olympus DAO. Protocol owned liquidity bypasses the need for external liquidity providers, instead resulting in the protocol itself providing liquidity to their own trading pair on DEXs. The key innovation to enable this is the “bonding process”.

Bonding process

Put simply, the bonding process involves the protocol itself selling their own token (e.g. OHM) in exchange for another token (e.g., ETH or DAI) or a liquidity pool token (e.g. OHM/ETH) from a buyer. The buyer is incentivised to bond (instead of buying tokens on-market) by the protocol selling their token at a discount (usually 5–10%) to the current market price, which is vested over a period (typically under a week) to prevent an immediate arbitrage opportunity.

The net result of the bonding process is that the protocols end up holding a large number of valuable tokens in their treasury. This process can be thought of analogously to how a reserve bank (i.e., the protocol) would sell their country’s currency (which they control) to buy a foreign currency from the market, and thus store this foreign currency in their treasury.

What do protocols do with the tokens in the treasury?

With the tokens received from the bonding process, the protocol utilises these as follows:

  1. Provide liquidity to liquidity pools on DEXs for their own token (e.g., Olympus DAO would act as the liquidity provider and provide ETH and OHM to the ETH-OHM pair on Uniswap), in the process collecting the transaction fees
  2. Invest the tokens to earn a return (e.g., lending the tokens, investing in a protocol project)

Creating a reserve currency

A by product of the protocol owned liquidity model is that because the protocol now holds valuable tokens in their treasury, the protocol can be now seen as being “backed” by assets. This can in theory create a price floor for the token (e.g., if the treasury owns 1 billion USD of ETH, the minimum market capitalisation of the protocol should be 1 billion USD) and allows the treasury to “defend” the price of their token through buying their tokens on-market (pushing the price up).

This argument should be viewed with caution, as the protocol will still be providing liquidity to their token’s liquidity pools on DEXs. If there is sustained selling of their token, this will drain the treasury of their reserve assets (as the protocol would contribute more of the reserves assets in the trading pair), in turn reducing the price floor. This can result in a negative feedback loop, with selling reducing the price floor, encouraging further selling. Noting however the protocol could decide to pull liquidity from their liquidity pairs, but this would in essence defeat the very basis of a protocol owned liquidity model.

Olympus DAO (along with other forks) have in-part implemented measures reduce this risk by offering large staking APYs (often >1000%) to reduce the incentive to sell (utilising the classic prisoners dilemma argument in game theory). It remains to be seen whether this APY inducement is sustainable in the long-run, underlying the need for protocols to create a clear value proposition to participants in order to maintain confidence in the token as a reserve currency.

Noting however that protocols can still utilise the protocol owned liquidity model without aiming or intending to create a reserve currency.

Liquidity-as-a-service (LaaS)

Perhaps a more enduring legacy of Olympus DAO is the concept of LaaS, launched through the Olympus Pro platform. This enables protocols to easily utilise the protocol owned liquidity model.

Extract of bonds listed on Olympus Pro’s marketplace

The platform serves as a bond marketplace, whereby users can purchase a bonds from protocols listed (paying Olympus DAO a transaction fee).

Marketplaces such as these should reduce friction in issuing bonds, providing a valuable matching service between protocols and capital providers that should continue to drive the adoption of this model in DeFi.

Advantages of the protocol owned liquidity model

  • In part addresses the mercenary capital problem, with protocols in theory paying a lower cost (in the form of a discounted tokens) to retain liquidity
  • Protocol keeps the trading fees from their own trading pair in DEXs
  • Treasury assets can generate revenue for the protocol
  • Assuming sufficient scale in the treasury, the trading pair should be able to absorb higher trades with less price impact

Disadvantages of the protocol owned liquidity model

  • Reliant on incentivising users to bond through a discount to the market price. More competition in this space may result in higher discounts being offered, which would dilute existing holders further
  • Systemic risk of protocols using this model to create a reserve currency, with the chance of sustained selling eroding the “price floor” and creating a negative feedback loop

Final thoughts

The protocol-owned liquidity model is an innovative solution to the mercenary capital problem and is likely to rise in popularity as a liquidity model. This will be in part driven by the advent of Olympus Pro (along with other competitor platforms) which creates a marketplace to assist other protocols in the bonding process. It is likely that DeFi protocols will use a mix of protocol owned liquidity and traditional liquidity pools going forward.

However, caution should be given to some of the promises of protocols that are seeking to bootstrap value into the protocol solely by the bonding process, in turn attempting to create a reserve currency. Long-term, these protocols risk a loss of confidence (particularly if the protocol is not providing a clear value proposition) leading to a sustained sell-off draining the value of the treasury.

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