Protocol Liquidity — The endless loop

I had no idea about the concept of Liquidity, I explored, so you don’t have to!

13 min readMay 4, 2022

In this post, we are going to understand Liquidity in DeFi, its internal components, and the current risks and drawbacks it has!

I’m writing this for anyone who’s just curious enough to understand Liquidity as a concept and how it is backing the DeFi ecosystem in spite of some potential drawbacks it has. I am keeping it simple for any newbie to understand this and get an overview of DeFi protocols.

This is structured into-

Understanding Liquidity mining in DeFi
The problems with the current protocol
Olympus DAO (Protocol owned Liquidity(PoL), bonds, etc..)
Impermanent loss and how it works?

Ready? Here you go 🚀

Liquidity Mining ⛏

Liquidity mining is an instrumental but puzzling power in the decentralized finance (DeFi) world. Liquidity miners do not get nearly as much exposure as application developers or venture capital, but DeFi protocols cannot function without them. Without liquidity — or enough tokens to support smooth transactions — Defi protocols are just lines of codes rather than applications that people can use.

“Crypto is built by code but composed of people”

With no big, central entities 🏦 to speak of, one of the defining features of decentralized finance is that it sources liquidity from users themselves.

Like centralized exchanges(CEXs), decentralized exchanges(DEXs) depend on liquidity. When founding a centralized exchange, it would be sufficient to get big institutions to provide either side of the assets, and the exchange would work due to order books. Decentralized exchanges, on the other hand, rely on automated market makers, in simple words getting liquidity from PEOPLE.

Suppose you go to Uniswap to exchange your ETH for USDT. you simply select the tokens, enter the value, and you get USDT in return for your ETH. But did you ever ask where the USDT came from or where did your ETH go to? 🤔

If not then the answer is a Liquidity pool: a reserve of crypto assets managed by a protocol that is readily available to allow users to swap easily.

Liquidity comes from other users, called liquidity providers or LPs. You can think of them as users incentivized by rewards or yield paid to them in exchange for leaving their tokens as part of the liquidity pool.

The problem

The above process feels justifying isn’t it? But there is a problem and that is-

Rewards are highest in exchanges where liquidity is lowest to attract LPs, but it falls again when the liquidity is restored to the protocol. Loyalty isn’t a thing here, if we had been given the chance to either earn 5% APY or 15% APY on our liquidity, we’d all certainly want the latter. This means liquidity is constantly flowing to whichever platforms offer the highest rewards, a dynamic known as mercenary capital.

Mercenary capital is the kind that flows in with short-term gains in mind and then exits. as soon as better incentives appear elsewhere they leave.

Here’s a good example. This coin launched on September 14th, and had almost half a million of liquidity on day 2:

This dynamic makes for a volatile DeFi ecosystem, where platforms are locked in for a constant struggle to maintain enough liquidity to attract users, while LPs are always seeking better rewards for their liquidity. It also leads to poor token liquidity of protocols after the native token rewards are dehydrated 🥀.

Though the top cryptocurrencies like BTC and ETH have enough trading volume for market makers to compete against each other for free. Smaller tokens and ICOs, on the other hand, face the “ICO liquidity trap”. This happens as there are not enough market makers working on providing liquidity for them.

ICO issuers face a bottleneck when trying to secure an exchange listing.
Crypto exchanges face significant setup costs to list a new token (due diligence, setting up cold storage, etc.) Therefore, they are not thrilled with the prospect of a new listing if they are not sure about its potential liquidity.
Investors (market takers) see lack of liquidity as a big showstopper as well. To start with, wide spreads limit the number of strategies they can adopt.
Also, a sudden rally in an illiquid token could trigger a bunch of FOMO investors to join, resulting in an unsustainable rally and pump-and-dump accusations in the end.

We can certainly say that,

“Whoever controls liquidity, controls DeFi”

so obviously in crypto, it’s all about community, about decentralization and so there is a concept where an issuer someone who issues a token can probably award a reward pool, and the reward pool can go to people who are proving that they’re providing liquidity as of a certain time so this fits the blockchain world very well because on the blockchain there’s already kind of segregated blocks on every timestamp and so it’s really easy to reward people.

Talking about people, by looking at chats on telegram, Discord, and Reddit, it might still seem that, people are not aware of the full potential of such decentralization. So, we often read, “What does yield farm ABC provide, why dumping, why not moon, etc.”

Many people. Nevertheless, all people want to make money by providing liquidity. One thing that is undervalued is the reason, WHY provide liquidity. Like centralized exchanges, decentralized exchanges depend on liquidity.

When founding a centralized exchange, it would be sufficient to get people to provide either side of the assets, and the exchange would work due to order books.

Decentralized exchanges, on the other hand, rely on automated market makers (AMMs). The main concept is to have a pool that keeps two sides of assets that are tradable (such as ETH & BTC). Thus, liquidity providers need to provide both sides. This approach comes with certain risks. One of the most known ones is Impermanent Loss. Interestingly, most people providing liquidity do not get it. Simply put, an impermanent loss (IL) is a difference between holding tokens in an AMM and holding them in a wallet.

The narrative with liquidity mining is not that flawless, it’s complicated. Yes, it’s complicated and far from a perfect solution for DeFi’s liquidity problem.

If a protocol keeps rewarding liquidity miners with a large number of its tokens, the value of its tokens will surely be diluted, if a protocol reduces or stops the token rewards, liquidity miners might move to other protocols that are offering high token rewards. The trade-off is not that balanced here as you can see!

Liquidity miners used to act as mercenary capital mostly. They keep moving to the protocols that give the highest rewards, and they often dump the tokens they earned quickly in case the token value is diluted with the ongoing incentive programs. What a relationship! Just like…

This unstable relationship often leads to a losing dilemma for the protocols and the liquidity miners: when liquidity miners start to dump the earned tokens of a protocol, the token price goes down, which makes the liquidity mining incentives less attractive, so more liquidity miners leave, depleted with liquidity the protocol becomes unusable.

The shortfall of the liquidity mining mechanism led to a series of innovations in the protocol ecosystem. Olympus Dao, known as a pioneer of DeFi 2.0, invented the concept of POL (protocol-owned liquidity). It designed a bonding mechanism through which it offers its own token at a discount in exchange for liquidity tokens. Protocols that adopt this model will control their liquidity rather than renting it from liquidity miners. Meanwhile, many protocols are adjusting their incentive programs to require liquidity miners to lock up the tokens they earn for a period.

OLYMPUS DAO: THE CALL FOR STABLE LIQUIDITY? 🌊

Olympus DAO is one protocol that sent waves through DeFi and tried to change the norms of everyone’s expectations from the space. Olympus protocol’s main strength lies in the fact that it can own its liquidity and therefore achieve a level of stability DeFi 1.0 could not. How does it do this?

To understand, let’s go back to the liquidity mining example I shared above. You’ve added liquidity and now you have the LP tokens. In the previous setup, you are free to unstake your LPs at any time and withdraw your liquidity if a better offer comes up — the dynamic behind mercenary liquidity.

But with Olympus, the transaction is not necessarily done when you receive your LP tokens. But instead, Olympus allows you to then sell your LP tokens of its token pairs — OHM-USDT, OHM-wETH, etc. — back to Olympus, in exchange for discounted OHM. So you the user are incentivized by the offer of discounted tokens, and Olympus gets the benefit of being able to control its liquidity.

The chart you saw in the introduction showed you what the total liquidity for a new project often looks like. Now here’s what Olympus’s liquidity chart looks like:

How does that work exactly? 🧘‍♂️

Say, you add OHM-USDT liquidity on Uniswap — you can then go to Olympus and use your LP tokens to buy OHM at a discounted price. This means you’re indeed passing on your control over the LP tokens, back to the Olympus protocol itself. This is known as “bonding”.

Now that Olympus owns the LP tokens that represent the OHM-USDT liquidity you added on Uniswap, it in fact owns and controls that liquidity. This method has proven extremely effective and has allowed Olympus to own over 99% of its liquidity across exchanges.

The traditional protocols have had to reward liquidity providers (LPs) with their own tokens. But this often just leads to a prisoner’s dilemma situation on who’s eventually going to break and sell first.

Since third-party liquidity providers are looking for quick returns, they’ll sell pretty quickly causing token prices to tumble. To counter this, Olympus buys the pool’s liquidity ownership. Currently, Ohm owns more than 99% of its liquidity.

Essentially it is Renting vs owning :

This post by Nat Eliason explains OlympusDAO and Liquidity problem very well.

Here’s an excerpt…

Tl;dr — The future promise of discounted OHM is helping Olympus own the liquidity. More precisely LPs are incentivized to stake rather than sell.

But things didn’t go so well with $OHM. The token which aims to be allegedly ‘the decentralized reserve currency of DeFI’ is losing its value like anything.

(there are multiple factors like uncollateralization, Algorithmic stablecoin, etc. I’ll leave that, for the next essay. So stay tuned!)

Though most importantly, the developers of Olympus DAO have enabled this same mechanism to be deployed across the DeFi ecosystem, via Olympus Pro, which offers its solution as a service to all DeFi protocols so they can also own their liquidity. So not only is Olympus pushing the boundaries of DeFi for its own tokens — but it’s also providing a stepping stone for the entire ecosystem. So we’re likely to see a bunch of new protocols change the face of DeFi going forward.

Impermanent loss

While using Liquidity pools you will come across a thing called Impermanent loss. It becomes important to understand, especially when interacting with Liquidity Pools.

Let’s look at AMMs to understand “impermanent loss”.

An AMM — is a type of decentralized exchange that relies on liquidity controlled by an algorithm, instead of using an order matching system. What exactly does that mean?

A centralized exchange (CEX) oversees the operations of traders centrally and matches the buying/selling orders using a central order book. For example, when you decide to buy 1 BTC at $42,000, the CEX ensures that it finds a trader willing to sell 1 BTC at your preferred exchange rate.

Whereas, AMMs use smart contracts to create their liquidity pools to facilitate trades — the idea behind this is to ensure there is always readily available liquidity, and minimize “slippage”.

> Coming back to Impermanent loss.
In an automated market maker, the value of your tokens is constantly adjusted to keep the value of token pairs in sync and to keep an equilibrium between the two tokens in the pair. What does this mean for the liquidity provider (you)? 👇

If you remove your liquidity at a time when the pool is adjusting to a significant price change in the market, you might find that — at that particular moment — your withdrawn tokens are worth less than if you had just HODLed. This is known as “impermanent loss”. It’s known as impermanent because the loss is only realized by the LP if they choose to withdraw their funds at that point, and normally corrects over time.

The graph below shows how price can impact the amount of impermanent loss a liquidity provider will experience. Let’s say, When a token increases 500% in price, you can see that the liquidity provider will incur an impermanent loss of approximately 25%. This is 25% less than the value of the tokens if they were simply held.

Another example can be

As more and more liquidity miners also get to understand that, a long-term win-win relationship with the DeFi protocols is the key to maximizing their return. So by directly communicating with DeFi protocol developers and discussing how to work together, they can help the protocols grow. They already own governance tokens, and now they are increasingly active in governance activities from voting to proposals. This means liquidity miners are taking on some institutional capital qualities, making bets on the ideas, and protocols they believe in, and backing their growth.

The shifting dynamics also make more and more liquidity miners recognize the advantage of pooling capital and knowledge together 🤝. Indeed, liquidity mining is a team sport. When liquidity miners organize, naturally they lean towards that crypto-native term — DAO (decentralized autonomous organization), projects issued their own tokens to incentivize active DAO members.

Since DAO are becoming forms of the organization behind DeFi protocols, we can expect more DAO-to-DAO collaborations between protocols and liquidity miners.

Currently, as we see many applications in DeFi are just on-chain replicas with a new UI of what we are familiar with in traditional finance from lending, and trading to derivatives. Holding or trading tokens is not that different from what people do with assets in traditional finance. But DeFi will not just have🏌 such things to offer, liquidity mining is a true innovation that is unique to DeFi. Its emergence reminds us that DeFi will bring about new forms of investment that cannot fit into the frameworks of traditional finance. That said, it will be worth monitoring the adoption of the DeFi 2.0 movement. As of today, many other projects are also adapting that path to acquire or rent out their liquidity.

One of the most compelling visions for blockchains is “the internet of value.” For value to be transferred, liquidity is an indispensable piece of infrastructure.

Wrapping up ️️🏌️

In the early days of DeFi, DEXs suffered from liquidity problems in the crypto market, when attempting the traditional market makers model. Liquidity pools helped by having users be incentivized to provide liquidity instead of having a seller and buyer match in an order book. This became a powerful, decentralized solution to liquidity in DeFi and unlocked the growth of the DeFi sector.

Liquidity pools may have been born from necessity and came with risks like Impermanent loss, but the innovation brings a fresh new way to provide decentralized liquidity algorithmically through incentivized, user-funded pools of asset pairs. As Protocol-owned liquidity becomes a kind of vertical unto itself. Olympus and its various forks, including protocols like Wonderland and Redacted, have accumulated large sums of CVX and other tokens with earnings potential from treasuries, that can now be used to generate returns.

The risks and shortcomings stated, I believe the fud and the complexity are just a matter of time and innovation.
Numbers give a good metric. You can track them when they compound. But It’s not as simple to cope with how innovation compounds. Even if the outcome is uncertain, the current set of projects emerging in the wake of the potent days of liquidity mining nevertheless represents a progression in how projects entice and incentivize deposits from users and even DAOs for good.

The fun lies in knowing the story so far and not knowing how it will play out. I like the fun part 😉!

What about you?

That was all about Liquidity. If you found this useful, why not share it with your friend (yes, that friend you’re thinking of!). And if I missed something or you have any questions about this, feel free to ping me on Twitter @inSitesh :)

Cheers to liquidity 🥂

Until then…

A special thanks to Aditya, Yash, and Rohit for their feedback and for proofreading the first draft.