The Liquidity Loyalty Problem

Author: Luke Posey

Compiled by: Odaily Planet Daily

Total Value Locked (TVL) is one of the most popular and easily misunderstood metrics in DeFi. Total Capital Allocation (TCA) may be a more accurate term. TVL implies that value is "locked" in the protocol, loyal and steadfast. Unfortunately, this is not the case for many projects. Short-term monetary games dominate. With few exceptions among blue chips, all narratives guide prices. Narratives, prices, and liquidity have a highly reflective relationship.

In this article, we broadly refer to liquidity as all liquidity associated with a project—its governance token trading pairs, all relevant liquidity metrics within its protocol, and so on.

We will demonstrate the disloyalty of liquidity through the following points:

• Liquidity only sticks in high-quality projects. Loyalty is also fleeting compared to traditional stock markets.

• The nature of unlocking early liquidity for everyone creates a massive risk premium. This is not inherently bad; it is just different.

• By design, early liquidity is less loyal than later liquidity.

• Token incentives driving liquidity are a band-aid solution to incentivize network activity and liquidity. The appeal of governance depends on the value and reputation it manages.

We will conclude by providing a series of policy steps that projects can take to appropriately adjust incentives and attract more loyal liquidity providers and loyal token holders.

Act One: Understanding What Drives DeFi Liquidity.

As a high-level metric, TVL effectively showcases the overall interest in funding DeFi over time. From DeFi Summer (2020) to Q2 2021, the capital growth rate in DeFi significantly outpaced that of Ethereum. It was easy to find yields, and liquidity was eager to stay in high-risk pools. With the popularity of staking pool 2, the underlying governance tokens of projects had healthy liquidity. DeFi experienced explosive growth, with the growth rate of TVL clearly surpassing the market cap of ETH.

Since then, cryptocurrencies have exited the ATH boom. As a result, the shift from risk-on to risk-off began, compressing corresponding yields. Liquidity slowly flowed out of pool 2 and into the stablecoin. If we consider Aave and Compound's stable pools as risk-free rates, yields have been compressed to historical lows due to the massive liquidity of stablecoins and limited borrowing. The risk premiums in risk pools above these yields are similarly sluggish.

During this period, almost all venture capital returns were affected. In most cases, token prices fell by over 60%, leading to corresponding declines in yields, as rewards for liquidity providers were paid in collapsing tokens.

The risk of impermanent loss (IL) forced many liquidity providers (LPs) out of these funds, depleting liquidity and creating a natural seller. Over time, as prices continued to decline, more and more LPs capitulated. Despite the heightened risk of IL, the liquidity of these farms also decreased due to falling prices.

When many LPs left pool 2 to take risks, they found themselves in the stablecoin market, searching for new yield sources. While DeFi had moved away from risk, the flight to safety had reached historic levels. The demand for stablecoins remained fundamentally unchanged.

Many of these stablecoins are solidly on-chain, creating attractive stablecoin opportunities in DeFi or preparing to increase trading volumes on decentralized exchanges to cope with the risks of cryptocurrencies.

This shift towards stable assets means that liquidity in risk pools has essentially dried up. And risk pools have been affected by low user loyalty. Nansen Research recently reported on the behavior of liquidity mining supported by SUSHI (MasterChef). Unsurprisingly, liquidity in most farms is highly unstable. In MasterChef farms, half of the farmers stayed for no more than 15 days. The chart below shows the distribution of days liquidity providers spent in a single farm.

Duration study of Nansen MasterChef farms.

This disloyalty is not surprising. Liquidity providers watch helplessly as impermanent loss devours their lunch. Take the buy-and-hold strategy of the popular governance token ALCX as an example. Holding the token at $1800 resulted in a net return of -80%, and considering ALCX's unilateral staking, the net return was about -70%. However, liquidity providers in the ALCX-WETH pool incurred a -65% loss while earning a comparable return under higher risk and significantly higher management fees.

IL Simulator

Curve, Aave, and Compound dominated TVL during this period, as nearly all their liquidity was concentrated in stablecoins. But naturally, as liquidity increased, so did the aforementioned low interest rates.

Curve and similar stable DEXs can be said to be the only games with relatively low risk and attractive returns in stable pools, which is why this capital continues to remain abundant. The competition for Curve yields became so intense that Yearn, Convex, and Stake DAO continuously purchased and allocated large amounts of Curve governance token CRV to secure potentially the best yields on the Curve dashboard. These measurements control how rewards managed by DAOs are distributed within Curve pools. Locking CRV (veCRV) votes determines how these rewards are allocated.

Data Source: Dune Analytics

Curve may have created the most powerful incentive structure in DeFi, incentivizing liquidity with governance tokens. They use CRV in their dashboard, leading to a large supply being allocated to productive uses, effectively locking up the vast majority of their token supply for extended periods.

Data Source: Dune Analytics

This created a powerful feedback loop, allowing tokens to maintain value under continuous and relentless selling pressure. Countless parties continuously mine and dump these tokens on the open market. Most other projects have not been so fortunate. Curve's strong liquidity and first-mover advantage have allowed it to maintain robust utilization in stable pools.

Most governance tokens have not experienced the same fate. Sparse usage and thin liquidity, like the anonymous tokens below, tell a consistent story:

As liquidity has nearly depleted, tokens now experience extreme daily volatility at any sign of buyers or sellers. With the aforementioned governance tokens earning returns through liquidity incentives, the ongoing selling pressure remains. The project relies on governance tokens to incentivize usage and maintain competitiveness.

Act Two: For Most "Greedy" Protocols, Current Token Design is an Inevitable Mid-Term Death Spiral.

For teams without publicly traded stablecoins, publicly launching their own governance tokens is problematic, especially if the team's salaries are paid in the project's governance tokens. A potential feedback loop exists:

• Limited loyalty from hired farmers, short-term locked venture capital, and team members needing to pay rent continuously sell new tokens into the market.

• Prices fall correspondingly due to increasing selling pressure.

• Teams must pay more and more tokens to maintain the same dollar salary.

• Farmers see their yields affected, either exiting or letting their positions get washed out, or increasing capital to cope with impermanent loss and declining token prices.

• As more tokens are sold on the open market, further issuance continues to depress prices.

• Over time, liquidity exits the pools as they can no longer bear impermanent loss, or they begin to lose confidence.

• Retail and venture investors question their confidence in the project. Many exit, further depressing prices.

• Liquidity experiences a death spiral, and the project's pool 2 is now effectively dead.

Due to the inherent risks and fleeting loyalty of early projects, more and more teams are encouraged to diversify their assets into more risk-averse assets. Of course, this requires trade-offs. Primarily, the community questions the team's trust in their project. In the early stages of a project's lifecycle, it can diversify funding and potentially do better.

If farmers and other stakeholders are motivated to engage in hired behavior, what motivates teams, users, and investors to hold governance tokens and provide ongoing liquidity? There are many factors, but primarily:

• Current or future cash flows rewarded in the form of fees, token burns, buybacks, etc.

• Marginal buyers driving up token prices (price driven by narratives, often driven by cash flow narratives—note the reflexivity of this relationship).

Governance as the only motivation for token holders is merely an illusion. It is a weak attempt to evade regulation, delaying the true cash flows of the protocol.

Token holders expect more. They anticipate future liquidity. In traditional markets, we often see liquidity premiums. Assets with good liquidity trade at a premium because investors have the ability to cash out. The same goes for cryptocurrency assets. Projects without liquidity commitments increase risks and decrease loyalty—just as TradFi market makers might avoid additional risks on the books through predictions, retail and professional liquidity providers in DeFi are also constantly monitoring risks. DeFi liquidity is often poor, making loyalty scarce.

A lack of liquidity loyalty means fleeing risk at the first sign of danger. Risk aversion marks a decline in token prices. A decline in token prices marks the exit of liquidity, and the exit of liquidity marks a decline in token prices.

Act Three: The New Paradigm of Early Liquidity Has Not Failed; It Is Just Different.

One of the hallmark innovations of the crypto revolution has expanded access to early liquidity. In many ways, this is the democratization of venture capital. The traditional model is that retail investors can only access companies through IPOs, direct listings, etc., over a span of up to 10 years. Now, traders and investors can access early liquidity at what can be said to be the seed pre-stage and seed stage through ICOs, IDOs, and early DEX liquidity.

It can be argued that this early liquidity has led to massive price premiums. Valuations in the space have been significantly exaggerated. This can be seen as reasonable because venture capitalists can obtain inherent liquidity premiums through public DEX liquidity at any stage. They no longer have to wait 10 years for exit events. Many venture capitalists are salivating at the prospect of significant retail exit opportunities even for failed projects. Winners will achieve returns of over 100 times, and even the worst losers may have shuffle, marginal profits, or recoverable losses.

This has created massive premiums, with many venture capital firms competing for early investment shares. However, as premiums continue to swell, valuations will exceed the premium value.

By design, early capital has lower liquidity. Venture capital intentionally involves lock-up periods and limited liquidity. The existence of secondary markets is to provide exposure, but ultimately, in traditional venture capital, the lock-up periods and long-term marriages between companies and investors are key. High-quality teams require investors to extend lock-up periods, and cryptocurrencies will soon face liquidation.

A 6-month lock-up period is simply not enough. Venture capitalists can easily reduce losses and abandon ship, selling their shares into a public market once their tokens unlock. They bear reputational risks, but short-term capital risks are still much more significant.

However, the pendulum on this topic may have swung too far in punishing venture capitalists' behavior. In many ways, the new model has turned all retail investors into venture capitalists.

The retail investment stage has historically been the exclusive domain of venture capitalists. If we are to impose lock-up periods on venture capital, perhaps teams can explore extending lock-up periods for the retail sector. Teams issuing governance tokens in IDOs and those holding pool 2 DEX positions should explore extending the lock-up periods for these governance tokens to 1-5 years and increase returns.

After all, these projects and investors intend to be around for about 1-5 years, right? The answer is often no. Teams and investors inclined towards short-term incentives should expect increased risks while seeking potential short-term returns.

Selling a basket of early product governance tokens as long-term bullish options may be wise. This is not because these projects may fail, but because risk premiums will be repriced in the coming years as these projects demand higher values for every project sold.

Act Four: Adjusting Incentives is a Complex Game That Requires Careful Consideration of Expected Outcomes.

Biology describes three types of symbiotic relationships in nature:

• Mutualism: Both parties benefit.

• Commensalism: One party benefits, and the other is not harmed.

• Parasitism: One party benefits, and the other is harmed.

In the initial stages of a project, almost all participants are engaged in mutualism. At the project's launch, the earliest investors and liquidity providers take on higher risks. These early investors are often vocal supporters and assist with marketing, development work, analysis, and more. Mutualism.

At some point in the lifecycle of these projects, this relationship turns into commensalism, where marginal token holders no longer guide the network, now taking on less risk with expected returns. Their engagement in the community is often lower. If they provide liquidity, it is often less loyal. If their profits and operations have at best a marginal impact on the project, their personal gains may be substantial. If their positions get washed out, the project benefits from their liquidity, but investors incur losses. Commensalism.

Finally, the third type is parasitism. They act purely for short-term results. They engage in extractive governance practices. They pursue outcomes that are only beneficial to themselves. They adopt dubious marketing strategies, relying on their influence to persuade marginal investors. From the investors' perspective, this may be an investment in private financing that seeks large allocations, short-term lock-ups, and contributes little to the project. From the project's perspective, this may be a project that covers the entire community or has never reached a certain development milestone. Parasitism.

For now, many in the field believe the time is too short. But perhaps that is okay. We are still in a cycle of rapid innovation. Short-sighted thinking and outpacing your competition can be very profitable. As more quality enters the space, long-term thinking will become more profitable.

Liquidity loyalty depends on the potential users of the project. These types of users will change as the project matures. Current user behavior is highly variable. There are good reasons for this. Innovation is developing so quickly that liquidity cannot coalesce around a team or codebase. Perhaps over time, more moats will form, and innovation will slow down. For now, concentrating risk and extremism is a foolish endeavor.

Act Five: With Wise Policies, Loyal Liquidity is Possible, Though It Requires Trade-offs.

With the right incentives and the collective buy-in of protocols and investors, the projects themselves can move towards success.

Before proposing some policy recommendations, what is the most certain way to maintain liquidity? Utilization.

If the underlying product has no users, token economics do not matter.

Utilization—delving deep into utilization, many projects and networks are true "ghost towns." They have active governance token mixes on DEXs but no reason for that liquidity to remain loyal.

Without utilization, narratives are weak. Cash flow without utilization is sparse.

If utilized properly, narratives become more robust. Cash flow with utilization is abundant. Our previous charts change…

Due to the aforementioned feedback loop, I believe that projects with long-term goals should wait longer to launch tokens or provide DEX liquidity. Early-stage projects should either persist in seeking private capital commitments to lock tokens from trades or accept the risks/trade-offs of providing early liquidity to their communities. If not utilized, be prepared for a chaotic journey. Note that even most projects with functional products cannot attract significant user growth and utilization of their protocols.

So far, we can view Sushiswap as the pinnacle of blue-chip DeFi. Even Sushi's user retention is struggling. Now imagine not a peak blue-chip project.

Data Source: Dune Analytics

Despite a plethora of rewards, innovations, top brands, and strong community-driven strategies, Sushiswap's user retention remains low.

Only a few projects have shown strong utilization and cash flow. Ironically, in many of these incentives, the incentives are actually the most fundamental, primarily because they can do so. Uniswap is a clear example. Uniswap's products do not have liquidity incentives. Underlying utilization drives fees, and these fees drive liquidity provider participation.

UNI token holders receive no commitments, even though popular sentiment is an expectation of future cash flows.

While many projects using Uniswap-v2 liquidity offer staking, v3 has managed to attract the liquidity and usage of the entire product purely due to the advantages of using fees. Capital efficiency and product advantages are solidifying DEX's overall dominance.

Data Source: Dune Analytics

In addition to high liquidity across all currency pairs, the governance tokens themselves also have high liquidity. In DeFi, the demand for Uniswap tokens is the highest. Utilization (almost) is everything. Without it, any short-term returns are merely a stopgap for long-term fate.

Owning Liquidity.

One unique way to achieve loyal liquidity is to keep liquidity in the hands of the project itself by owning the project. Allow users to buy and sell tokens, but take measures to hold a significant portion of your own liquidity. OlympusDAO is a perfect case study.

OlympusDAO proposed the first solution to the loyal liquidity problem. The DAO owns over 99% of the liquidity of its reserve currency. It achieves this by selling bonds at a discount to tokens. The bond term is 7 days. It sells these bonds to acquire Sushi liquidity positions (SLP) or to obtain stable positions. Over time, selling SLP bonds increases the DAO's ownership of liquidity, currently holding over 99% of SLP in OHM-DAI and OHM-FRAX.

Data Source: Dune Analytics

For OHM, this means acting as a backing for its reserve currency. For other projects that choose to issue bonds, this may mean needing dedicated funds to pay for developers, marketing, and other expenses.

It is expected that more projects will adopt this self-owned liquidity structure over time, holding more and more LP positions by selling bonds with their native tokens. Additionally, owning the project's own liquidity allows it to continuously collect fees from the liquidity pool. In this way, even if the token experiences downward fluctuations, they hedge by collecting fees.

Curated loyalty. Accept the trade-offs of slowing growth.

Several different methods of locking, authorizing, etc., have been tried in DeFi with varying degrees of success. Primarily:

• Locking unilateral staking positions, liquidity position incentive mechanism revolving doors, longer lock-up incentive mechanisms, etc.

• The cash-out period for token rewards can disperse selling pressure/delay time.

• Private agreements with investors to become LPs on DEXs, market makers on CEXs.

• Expanding derivative investment channels for LP positions. More flexible hedging means less need to exit positions.

The simplest way to mitigate liquidity shocks is through locking. Although unilateral locked staking positions do not directly stimulate liquidity, they mitigate the blow to capital allocators. CREAM serves as a good case study. Gradually increasing APY over a longer time frame will incentivize stakers at all levels. Despite low liquidity, selling pressure remains at healthy levels due to token holders maintaining stability and liquidity loyalty.

Tokens committed to a 4-year lock-up period account for a maximum of about 10% of the 3M token circulating supply during the 4-year lock-up period. The number of tokens locked at each layer decreases. Stakers can receive healthy rewards, while the protocol mitigates the blow by kicking the problem down the road.

The expectation for a project is that over 4 years, they either find their target and experience healthy growth or fail completely. If they experience healthy growth, liquidity will be strong; any large token holders will have significant liquidity over 4 years if they wish. If they fail, then the discussion about liquidity becomes moot.

So far, CREAM's users/lenders are healthy and continuously growing, combined with loyal capital, which is a successful combination for CREAM's market cap, but the project's liquidity is thin, especially during this risk-averse period in DeFi. Holders prefer to hold tokens rather than high-risk LP positions. The good news is that CEX liquidity is growing, with FTX and Binance providing healthy markets for CREAM/stablecoin pairs. However, the total liquidity on DEX and FDV remains low for this project.

"How can I help you?"—Anonymous VC

A small portion of crypto venture capital firms are highly technical, with their technical niches spread across research, security/auditing, token economics, and more. The vast majority of VC firms are less technical, using capital as the primary means of value addition. Smart founders obtaining large amounts of funding from new investors should explore formal agreements with investors to provide liquidity, preferably in the underlying pairs, but guiding utilization elsewhere can also indirectly promote network growth, generating interest in the underlying pairs.

In lending protocols, this may mean that investors are the first to deposit in the lending market, initiating a stablecoin pool or protocol's underlying token of $500,000 to millions to encourage others to follow. In DEXs, this may mean increasing capital for strategic pairs, likely symbolic of the project. Founders should not hesitate to ask investors to participate in these plans and lock any returns obtained through their investments.

More than one smart founding team has recently rejected investors who cannot commit to reward lock-up periods. Do not hesitate to get more from your earliest investors.

Finally, opening derivative channels can enhance the flexibility and loyalty of liquidity providers (LPs). From all angles, many LPs are more willing to follow this ship, regardless of the outcome. Adjusting positions incurs tax liabilities and increases complexity. Currently, most LPs are either restricted from accessing crypto derivatives or do not have products that meet their expected risk/reward configurations.

LPs can utilize derivatives to hedge positions, retaining some returns in upside scenarios while protecting capital in downside scenarios. Expanding derivative trading channels will allow more LPs to stay in the industry. For example, I might choose to continue rolling put options to hedge against the underlying of my LP position. Below, we simulate the returns of various put options; obtaining more options targeting our underlying assets, especially options for regulated environments like the U.S., would be a positive step in the right direction, lending to more hedged liquidity providers.

Derivatives built specifically to hedge short-term losses may also be an interesting product—we will explore this idea further in later articles.