The DeFi ecosystem has developed liquidity incentive schemes that make it possible for a token issuer to incentivise liquidity providers and develop enough depth to attract buyers.
This trend has become a standard playbook in crypto decentralized exchanges to the point that “bribing protocols” have been built on top of all veDEXs. The goal of these protocols is to harness value from the DEX itself and drive the allocation of its native emissions in a “coordinated” fashion. After two years of evolution and as we observe some markets reaching maturity, we can ask ourselves if incentivizing veTokens holders' votes to direct DEX native emissions toward a specific pool systematically helps attract more liquidity provision to this pool ?
Relationship between incentives and liquidity depth
How to assess liquidity needs
Assessing liquidity needs in the decentralized finance (DeFi) ecosystem is crucial for ensuring the smooth functioning of exchange markets and preventing price slippage. By evaluating factors such as Automated Market Maker (AMM) type, average trading volume, and holder personae, we can gauge the adequacy of liquidity and identify potential bottlenecks or inefficiencies.
More researches at: https://arxiv.org/pdf/2307.13772.pdf
How to protect your token
Within a vote incentive market, protecting your token value and distribution can be achieved via incentivizing liquid lockers layers of vote (e.g vlCVX or vlAura ), the explanation behind this phenomenon is that delegation addresses allow users to obtain higher yield with smaller principals and thus attracts a wider underlying delegator base with stronger compounding habits, although this can seem paradoxical due to the absence of decay in voting power over the lock duration, which is equally shorter and fits the needs of a majority of DeFi users.
Efficiency of emission driven liquidity
From the DEX perspective
A DEX’s most important metrics are volume and TVL, and there is no natural incentive for veToken voters to prioritize pools that generate such growth. If this kind of incentive existed and large voters ignored it in favor of their special interest pool, external players would be financially motivated to lock veTokens and capture that incentive.
“Balancer was awarded 1.2 million $ARB token as part of the Arbitrum Short Term Incentives Program (STIP), to support emissions directed toward the DEX’s pools. However, when looking at the pools receiving veBAL votes there is a clear differentiation. Some pools are growing based on $ARB yields, generating decent volume and or fees and are examples of what Balancer hopes to see with STIP. However, others seem to be more yield farming plays, with basic ERC-20 tokens that don’t generate much volume, engage with advanced balancer tech, or generate fees through the core pools program.”
More details at: https://forum.balancer.fi/t/bip-522-arbitrum-lgp-and-stip-adjustments/5473
From the Token issuer perspective
Efficiency for the token issuer often translates into TVL growth on pools pairing the issued asset, and into value generated for the project’s treasury that can be calculated by subtracting value spent incentivising votes to the overall value farmed by protocol owned funds from emissions attracted toward the pool.
On a different note, token issuers also utilize incentives to attract new users to their assets. By offering a higher yield than the competition, token issuers become an appealing solution for new clients. This strategy allows them to draw more TVL to pools containing the assets, leading to easier swapping of other tokens within their token. As a result, users experience less slippage, increased volume, and the flywheel can continue to spin. This mechanism leads to greater usage of the token issuers' products, resulting in fees flowing back into the treasury. The key for the token issuer is to strive for an equilibrium where the fees generated from the product surpass the value spent incentivizing votes.
Ultimately, token issuers leverage incentives to influence user behavior towards their products. This becomes particularly advantageous for token issuers dealing with pegged assets. A notable instance is the Liquidity committee within AAVE, which employs incentive-driven liquidity to restore GHO to its peg. Remarkable progress was achieved bringing GHO back to 0.98.
Another example involves the utilization of Conic's omnipools to uphold the peg and enhance the efficiency of CRVUSD. Through incentivizing either the CRVUSD or the USDC omnipools, vlCNC (and consequently, Curve incentivizing vlCNC holders) assumed control over the interest rates of CRVUSD. Daesu delves into this concept in a detailed article, accessible here. Moreover, we may witness this vision extending to additional pegged assets on various veDEX platforms, with protocols such as Opal and Conic v2 rekindling interest in omnipools.
Bribe markets are undoubtedly a transformative element for token issuers, evolving into liquidity hubs where liquidity is available at the most competitive prices and poised to adjust based on the instructions of bribers and voters.
From the user perspective
For governors, the efficiency mostly depends on how much vote incentives creators are willing to pay to attract emissions towards a pool, basically efficiency for governors and incentive creators are inversely proportional.
When a market growth is not driven by emissions, fees generation is responsible for traders behaviors, hence large (institutional) LPs often dominate low-fee pools, frequently adjusting positions in response to substantial trading volume. In contrast, small (retail) LPs converge to high-fee pools, accepting lower execution probabilities to mitigate smaller liquidity management costs.
Liquidity providers type
Mercenary Capital
The first and largest category of liquidity providers (speaking in terms of demography) is the mercenary capital, they can also be called profit maximalists. This personae, no matter its size, will shift liquidity from a pool to another to seek for the best yield opportunities, the higher the APR generated the higher the chances of attracting this capital toward a pool, however it is not loyal nor sticky and will most likely dump rewards instead of compounding it to take part in the protocol governance or overall flywheel.
PoL farming
The second most widespread category of liquidity providers into veDEXs are Protocol Owned Liquidity (PoL) farmers. Taking advantage of the $$ of emission captured by the pool per $$ spent on voting incentives ratio. Many projects employ net positive strategies allowing them to convert their native token, which is often weaker on the market, into the DEX native token distributed through emissions for an average 20% discount. It also enables the PoL farmer to diversify their treasury without the burdens of slippage or price impact.
Passive token holder
The last category of liquidity provider we can observe on veDEXs is way more sticky and unaffected by small or punctual changes in virtual APR computed on a weekly basis. The token holder looking for passive income with minimum management burdens will update its position at a very low frequency and often make use of auto-compounder protocols.
In conclusion, we have identified the personae and habits of the majority of players within the veDEX LPs game; in the next article we'll see how Paladin will evolve in 2024 from its initial design as an incentive hub dedicated to protocol governors, to a more comprehensive role as a central node serving to optimally coordinate the dynamics of cash flows between liquidity seekers and suppliers.