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DeFi Liquidity Challenges and DeFi 2.0 Liquidity Incentivization Solutions

The dizzying rise of the decentralized finance (DeFi) sector during the 2021 DeFi summer is one of the most inspiring blockchain sector occurrences since the release of bitcoin in 2009. Compound had launched its COMP token a half a year earlier, an action that drove the fledgling market from a $2 billion to a $3 billion total value-locked figure in two weeks.

It had taken the sector two and a half years to rise from a zero TVL to the $1 billion mark. Then on July 7, 2020, it breached the $2 billion level. After that, pundits began to issue warnings that the DeFi sector could be a bubble.

But, by January 2021, investors had quietly stashed $15 billion worth of crypto asset liquidity in protocols such as Compound, Aave, and Maker. It seemed like such a formidable amount at the time. But the best was yet to come.

Soon more investors were locking up their idle ether, BTC, and USDT in DeFi protocols as collateral to enjoy decentralized lending and borrowing protocol’s high yield rates and liquidity provider reward tokens.

Early blockchain innovators became more skeptical. They warned that while this new gold mine was bringing much-needed liquidity to the sector, it could collapse under the weight of user losses and cascading liquidations.

However, most pundits reckoned that battle testing the existing DeFi sector using real money would create hardened systems with well-outlined risks. By mid-2021, the DeFi summer was full-on, as 235 DeFi protocols went all out to capture liquidity providers.

At least 200 of these projects ran on the Ethereum network paying crypto-asset owners 5% to 8% yields. By November 2021, the sector had a massive $107 billion total value locked. However, that figure has slumped to $38 billion, proving that DeFi has enormous risks that, if not tamed, could lead to failure.

DeFi 1.0 liquidity challenges

Most market outsiders were easily wowed by the torrid activity and high yields in the sector. The feverish investment activity prodded them to pour more liquidity into the industry in search of more income.

Unbeknown to many onlookers, the sector’s liquidity provider incentives have created a massive liquidity crisis. As per Nansen data, most DeFi yield farmers provide liquidity to new projects and exist within the first five days of earning yield.

At least 50% of this mercenary capital would exit projects searching for greener pastures in the first 15 days of entering a farm. Only 13% of yield farmers would maintain long-term contracts. More data shows that 42% of yield farmers would join a yield farming project and exit on the first day.

A massive 70% of yield farmers pulled their capital from DeFi liquidity farms by a protocol’s third day of operation. Moreover, as per Nansen’s observations, a yield farm’s reward emission rates would begin to slip block by block after launch.

Lower emission rates diluted rewards over time as more mercenary capital got wind of insane reward systems. “Capital is indeed mercenary in DeFi, and users would rather put their capital to work elsewhere. Don’t fall behind!”, Nansen warned.

That said, as long as the larger cryptocurrency sector was in full bloom, DeFi protocols would continue to act as an accelerator for investment income. But unfortunately, 2022 ushered in icy weather as the Fed kicked off its interest rate hikes.

The bear market coupled with the Terra UST debacle has at long last brought to pass the liquidity crisis forewarned by the sector’s critics and enthusiasts. Celsius, a crypto lending platform, was one of the first projects to suffer the rising DeFi liquidity crunch.

On June 13, 2022, a month after Terra’s collapse, Celsius halted its customer’s crypto transfers, swaps, and withdrawals. The company said that it had taken this action “to put Celsius in a better position to honor, over time, its withdrawal obligations.

“We are taking this necessary action for the benefit of our entire community to stabilize liquidity and operations while we take steps to preserve and protect assets,” they added.

That said, a week earlier, on June 7, 2022, Celsius protocol’s ominously titled article “Damn the Torpedoes, Full Speed Ahead” had reassured the Celsius investors that they were liquid to avoid a bank run event.

“Celsius has one of the best risk management teams in the world…Celsius has the reserves (and more than enough ETH) to meet obligations, as dictated by our comprehensive liquidity risk management framework,” they wrote.

It turns out that Celsius had staked user assets in Lido Finance. Celsius would stake user deposits in platforms such as Lido, earning stETH, which would increase in value as its staking deposits gain more rewards.

Unfortunately, Lido’s staked ether (stETH) , which represents the value of ETH on Ethereum’s Beacon Chain ether, lost its 1:1 claim to ETH. stETH, the crypto asset that powers the massive DeFi lending, borrowing, and casino lite protocols, was trading 7% lower than ETH by mid-June 2022.

As stETH lost its parity with ETH, panic led to stETH sell-off. More so, ether holders are rapidly swapping their stETH for ETH, then to fiat or stablecoins and exiting the market due to factors analyst Andrew Kang refers to as major imbalance flows in eth.

Kang states that the ongoing bearish sentiment in crypto is pulling out massive amounts of mercenary capital from whales and VCs, who have found themselves uncomfortably illiquid in the cold of crypto winter.

They are selling off ETH to remain liquid as illustrated by the Three Arrows Capital May 27 10,000 ETH transfer to the FTX exchange. Kang warns that while genuine Ethereum enthusiasts will hold the bag to the very end, large-scale CeFi investors will limit their exposure to ETH.

Retail holders are also cashing out because they are “bleeding in all directions” .”On the other hand, miners and short-sellers will also sell out as ETH plunges to the $1000 market.

Celsius critics have referred to its teams as degens hypnotized by the eye-popping returns that took down the Terra project. But, the Celsius and Lido projects’ liquidity crisis could signify a wider DeFi-wide liquidity crunch. This event could lead DeFi to a 2008 economic crunch, turning it into Shadow Banking 2.0.

DeFi 2.0 liquidity incentivization solutions

The crypto-wide liquidity crunch often comes to the forefront when giant whales go on their crypto sell-off phases. Their actions heavily impact the DeFi sector due to existing sell pressure caused by restless liquidity providers.

Most traders move from one protocol to the other siphoning juicy mega yields only to dump tokens and move to the next protocol. The heavy presence of mercenary capital in DeFi 1.0 misaligns the projects and liquidity provider goals.

Most liquidity providers do not believe in the longer-term sustainability of the protocols that they farm yield on. Projects, however, need liquidity providers with a long-term interest in their protocols. Unfortunately, this challenge’s negative feedback loop eventually leads to project failure.

The long-term believer in the protocol will eventually become disillusioned, embracing the short-term investor mindset. Finally, when a market-wide crash comes calling, liquidity providers will move their assets in reaction to bearish sentiment, causing a liquidity crisis.

The ongoing Ether bearish sentiment is partly fueled by fear that the Merge may lead to a staking exodus. That said, the Ethereum network has seen to this eventuality, ensuring that ether withdrawals kick off six months post the Merge at daily rates of 30,000 ETH.

Ethereum’s EIP-1559 updates also continue to burn more ETH than miners produce, lowering inflation. While these developments will have a favorable outlook on the DeFi market, innovators in the sector are building DeFi 2.0 liquidity incentivization solutions that could get rid of the mercenary capital crisis.

Projects such as Olympus DAO purchases liquidity from investors and gives them discounted OHM. OHM is the project’s native token. Investors that hold OHM vests it for five days earning 20% more tokens each day, effortlessly eliminating the token dumping for quick profit.

Olympus’s liquidity may never concur on these sort of liquidity crisis like DeFi 1.0 protocols. These processes also attract long-term investors since there is a lower risk of liquidity drains, token dumping, and liquidity loss.

By eliminating liquidity rewards, DeFi 2.0 protocols have lower operating expenses and are more sustainable than their counterparts. In addition, DeFi 2.0 liquidity incentivization solutions align the long-term interest of the Defi project to the of the token holders creating a positive feedback loop and confidence in the future of DeFi.

Convex Finance, on the other hand, improves Curve Finance’s user experience through a one-stop CRV pledging platform. In addition, their DeFi 2.0 solution will enhance CRV holders’ compensation. Uniswap V.3, on the other hand, offers its users attractive incentive schemes via its DeFi 2.0 capital efficiency protocols.

Mimo Protocol now integrates Uniswap V3, giving PAR holders a wide range of passive/active investment strategies for higher returns in its liquidity pools. Consequently, Uniswap V3 is attracting more trading pair liquidity and offering more interest than V2.

Moreover, PAR holders will enjoy better trading between their stablecoin holdings and other cryptocurrencies due to Uniswap V3’s efficiency protocols.

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