History of Reward Programs in DeFI
The foundation of decentralized finance was established in the first place to tackle the woes of the traditional financial systems. Barriers to entry, centralized power structures, and lack of ownership of funds were the fundamental problems that called for an improved financial system. DeFi refers to the wide range of decentralized applications that disintermediate traditional financial services and unlock entirely new financial primitives. More specifically, DeFI offers Decentralised exchanges for reliable swapping, decentralized lending and borrowing platforms, stable pegged currencies, etc., for the users. For the seamless operation of these applications, liquidity plays an important part. Therefore, liquidity pools provide much-needed liquidity, speed, and convenience to the DeFi ecosystem.
“Liquidity is one of the most important resources in the Web3 world, and whoever controls liquidity controls DeFi”.
Newer projects or protocols need to source enough liquidity by giving incentives or rewards in some form to the liquidity providers. Projects who design their incentives intelligently win massive power and wealth. Most incentive design in DeFI is focused on solving two problems:
- Discouraging people from selling the protocol tokens
- Encouraging people to make the protocol token more liquid
Keeping this in mind, In this article, we will look into the past innovations that set the stage for the DeFi 2.0 movement and introduce the liquidity problem that DeFi 2.0 protocols are attempting to solve. We will look into the reward/incentivization programs of DeFI 1.0 protocols and discuss the limitations. The limitations of these reward mechanisms paved the way for a range of novel new services, such as bonds, Tokemak Reactors, which put forward a new way in which DEFI protocols attract fresh deposits.
THE NEED FOR LIQUIDITY
Liquidity is one of the primary goals of any developed financial market. With no big, central entities to speak of, one of the defining features of decentralized finance is that it sources liquidity from users themselves.
Let us take the example of Decentralised Exchanges(DEX). DEXs effectively act as an alternative for centralized order-book exchanges. The most popular DEXs (Uniswap, Bancor) employ an AMM model known as a Constant Product Market Maker (CPAMM). There are a few dex models out there, but the most common one that we look into is the Uniswap model.
For handling trades, DEXs form pools, which are groups of tokens held in specific ratios. For example, an ETH-USDC pool has ETH and USDC and allows trades between ETH and USDC. So now, instead of trading with other people, a user will trade with the pool.
Trades work because the pool has enough assets in it to handle them. Under the Uniswap model, price is calculated as the ratio between those two assets in the pool. If there are 2 ETH and 4000 USDC in the pool, then 1 ETH = 2000 USDC.
Where do the pool and its assets come from? Liquidity Providers (LP)! DEXs pay the community to provide the liquidity that enables trades. LPs receive an LP token representing their share of the liquidity pool and the fees earned from facilitating swaps.
Figure: Uniswap Pool (Courtesy)
However, fees alone are not a sufficient economic reason to provide liquidity. LPs are constantly exposing themselves to the risk of impermanent loss in exchange for small fee revenue from swaps. Without sufficient liquidity, the swap function of a DEX becomes limited in utility, with users required to pay astronomical prices for large swaps due to slippage. This led to one of the most prominent problems that currently exists in DeFi: the liquidity problem.
So, without a sufficient level of liquidity, the slippage induced by swaps discourages users from participating in a DeFi protocol’s ecosystem. Furthermore, without users participating through token transactions, there isn’t enough fee volume generated to incentivize liquidity providers to pool their tokens and provide liquidity.
As a result, another crucial DeFi innovation was born. Rewards based on LP tokens became the primary way of bootstrapping liquidity for new DeFi protocols, a process known as yield farming.
Yield farming or liquidity mining in DeFi rewards users for providing liquidity or other value-adding services to a dApp’s ecosystem. In essence, yield farming rewards incentivize users to generate value for an on-chain protocol. The idea behind yield farming is simple. Users provide liquidity for an exchange pair on an AMM protocol, receive an LP token (LP = liquidity provider) for their trouble, and then stake the LP token for returns that are compensated in a project’s native token. This implementation gives the third-party LPs a compelling economic reason (higher yield) to provide liquidity.
So, by providing liquidity, a LP gets a shot at two rewards:
1. A cut of the trading fees that DEX charges per trade.
2. Some form of token that anyone can provide. This could be the DEX itself or one of the projects managing one of the tokens in the pool, incentivizing people to make their token liquid and tradable. Unfortunately, these rewards don’t exist for every pool.
𝗔𝗻 𝗲𝘅𝗮𝗺𝗽𝗹𝗲: On Sushiswap (which uses the Uniswap V2 model), the USDC-ETH pool currently earns 2,669 SUSHI tokens per day. A user can take $200, convert half of it to ETH and half to USDC, and put it into the pool. In exchange, Sushiswap will give the user an LP token, representing their share in the pool. Now the user can stake the Sushi LP tokens to the farm, where the user can get their share of the 2,669 SUSHI tokens. Using the price of SUSHI, the user can then calculate how much percentage they are earning by staking their tokens in the farm.
One of the earliest pioneers of yield farming was Synthetix. Synthetix launched a liquidity mining mechanism in 2019 to reward sETH/ETH liquidity providers on Uniswap. The users who deposited their sETH/ETH liquidity pool tokens from Uniswap into a staking contract earn a proportional amount of SNX tokens (Synthetix’s native token) to their share of liquidity provided.
The next iteration of yield farming — still often used in the market — was popularized mainly by Compound, a decentralized money market, by the launch of its COMP governance token in June 2020. Compound rewards users with COMP for both supplying and borrowing capital on the platform.
LIMITATIONS OF YIELD FARMING
Though highly effective, yield farming does not fully solve the liquidity problem due to the particular limitations of long-term yield farming initiatives. This is because of the supply dilution, an inherent feature of yield farming.
Rewards are highest in exchanges where liquidity is lowest in order to attract LPs, but fall again when liquidity gets restored to the protocol. Loyalty isn’t a thing here: a user would undoubtedly want the latter if given a chance to earn 5% APY or 15% APY on their liquidity. This means liquidity is constantly flowing to whichever platforms offer the highest rewards, a dynamic known as mercenary capital. Founding teams distribute native tokens to liquidity providers and provide additional sources of yield, incentivizing liquidity providers to keep their liquidity locked in AMM pools. However, as more tokens are allocated to third-party liquidity providers, an increasing percentage of the total token supply is given to rented liquidity, with liquidity providers able to remove their liquidity at any time and sell their earned LP staking rewards. According to Andre Cronje, liquidity mining is an imperfect tool that attracts “liquidity locusts” — temporary “farmers” who take their rewards and leave for the next opportunity.
Another emerging alternative came out from Curve, a DEX, similar to the Uniswap or Sushiswap. They introduced a “vote locking” feature in August 2020. The reward mechanism in the Curve resulted in “The Curve wars”, which we will explain next.
Curve is an AMM platform with many similarities to Uniswap and Balancer. However, it differentiates itself by accommodating liquidity pools of similarly behaving assets like stablecoins or wrapped versions of assets such as wBTC and tBTC. This approach allows Curve to use more efficient algorithms and feature the lowest fees, slippage, and impermanent loss of any decentralized exchange (DEX) on Ethereum.
Curve can dramatically reduce the price slippage for large transactions between stable pairs and enable much more efficient trades. This made Curve the go-to platform for doing swaps between stablecoins, and they consistently have significantly more Total Value Locked than their competitors:
Figure — TVL Data
Another part of Curve’s magic is the incentive structure around its governance token: CRV.
When a user provides liquidity to a trading pool on Curve, they earn a share of all the trading fees on that pool. But they also earn some CRV tokens as a bonus incentive for providing liquidity to that pool.
For example, If a user adds some DAI, USDC, or USDT to 3pool, the liquidity provider will make about 0.14% APR in trading fees. But the LP can earn up to 1.08% APR from CRV rewards.
Fig — Pools in Curve
If this were all there was to the model; Curve would have a problem. There’s no reason to hold CRV tokens so that people would dump them immediately, and the price would be near zero. That hasn’t happened, though, because of their veCRV model.
Automated market maker Curve introduced a “vote locking” feature in August 2020. This allowed CRV holders to lock their tokens in exchange for veCRV (voting escrow CRV) for four years. “veCRV” stands for “Vote Escrowed Curve,” and the only way someone gets it is by escrowing their CRV for voting.
VeCRV, in turn, grants the ability to vote on which liquidity pools receives a boost to CRV reward emissions, with voting power weighted in favour of those who locked their tokens for more extended periods.
It appeared as if it were a tool for individual farmers to maximize their returns; however, other protocols have proven to be the primary benefactors of this system rather than individual farmers. Accumulating more CRV became the main aim and resulted in the “Curve Wars.”
So, In Curve protocol, the user has a dual incentive to lock up your CRV.
- Earning from staking LP Tokens
- veCRV holders earn passive income (Current APY around 10%) and ability to vote for the pools in the Curve ecosystem.The more votes a pool gets, the more CRV LP stakers will receive, and so theoretically more people will stake in that pool.
Curve consistently emits more CRV tokens while also incentivizing people not to sell them. Therefore, it makes the most sense to provide funds to the liquidity pools, claim the CRV rewards often, and then stake them for more veCRV so the reward rate increases.
Let’s quickly recap what is going on in curve:
- Curve controls more liquidity than any other DEX.
- If someone locks CRV tokens for veCRV, they earn more rewards from the Curve pools to which they have added liquidity. For example, a user provided liquidity to 3 pool receives base APY + Additional rewards (based on the amount of veCRV they are holding)
- veCRV also lets the user vote on which Curve pools get more rewards.
- Protocols compete to acquire more veCRV to get enough liquidity for their token.
Convex Finance has accumulated a whopping 43% of CRV tokens and is considered the winner in the game. Convex also enabled a bribe ecosystem where platforms like Votium come into the picture.
DeFi 2.0 refers to a few emerging DeFi projects that hope to revolutionize the common problems associated with liquidity provisioning and incentivization. In addition, they provide alternatives and supplements to the yield farming model, giving projects a way to source liquidity that can sustain them for the longer term.
It is out of the scope of this article to discuss all the new projects in this space. Instead, I will introduce them and briefly explain the motivation behind each of them.
PROTOCOL OWNED LIQUIDITY MODEL
One solution that has risen to the forefront of the DeFi community in 2021 is OlympusDAO’s bonding model, which focuses on Protocol-Owned Liquidity (POL).
We have already written some posts regarding the Olympus DAO model, and the reader should refer to them for a better understanding of the protocol.
DIRECTING LIQUIDITY WITH TOKEMAK REACTORS
Another prominent protocol in the DeFI 2.0 paradigm is the Tokemak Reactor. Tokemak is a decentralized crypto liquidity engine created to address the inefficiencies of liquidity bootstrapping techniques by DeFI 1.0 protocols.
Tokemak can be thought of as a decentralized market-making platform and a liquidity router that disaggregates traditional liquidity provision and market making for DeFI.
Tokemak enables users to both provide liquidity and control where that liquidity goes.
Liquidity Providers deposit single-sided assets into individual Token Reactors and/or Genesis Pools (ETH, USDC) and earn yield in TOKE, Tokemak’s native protocol token.
Liquidity Directors stake TOKE into individual Token Reactors and vote how that liquidity gets paired from the Genesis Pools and to what exchange venue it gets directed. They also earn a yield in the form of TOKE.
DeFI 1.0 is comprised of fragmented, unpredictable, and expensively sourced liquidity. Builders of new projects bear massive costs pursuing liquidity solutions through incentivized “pool 2's,” which can dry up when the incentives are exhausted. Providing 50/50 paired liquidity is expensive for an individual and has the looming risk of impermanent loss.
This article has explained the need for liquidity and how different protocols implemented different reward program strategies to fetch maximum liquidity. We identified that the approach adopted by DeFI 1.0 protocols resulted in mercenary capital. This is one of the main limitations that DeFI 2.0 protocols tried to solve. Our upcoming articles discuss the TONStarterV1 reward program and various approaches for the TONStarterV2 Reward program.