Compilation of the original text: Deep Tide TechFlow

Compilation of the original text: Deep Tide TechFlow

In the DeFi space, liquidity is crucial.

Liquidity refers to the ease with which an asset can be converted into cash. The more liquid an asset is, the easier it is to cash out, and vice versa.

In DeFi, liquidity is measured by price slippage, the difference between the expected price and the execution price when an asset is traded on automated market makers (AMMs) like Uniswap. Better liquidity reduces price slippage, makes trading more efficient, and benefits all participants. Therefore, in DeFi, projects have an incentive to create deep liquidity for their native tokens to accumulate value and attract more users.

However, the Total Value Locked (TVL) charts for many L1 and dApps look to share a similar fate - a rapid burst of liquidity and growth followed by a marked decline. DeFi learned the hard lesson that acquiring and retaining liquidity over time is much more difficult than building it in the short term.

As top market makers such as Jane Street and Jump Trading wind down their participation, the need to design a sustainable token model becomes even more important.

Liquidity comes...liquidity goes.

Liquidity mining refers to the mechanism of incentivizing users to provide liquidity for tokens through native token rewards. Pioneered by Compound and Synthetix, it has become a common mechanism for DeFi projects to drive growth.

But we will soon find out that this approach is extremely unsustainable in the long run and a bad business model. Protocols are constantly struggling as they need to generate enough revenue to cover emissions-related costs. Below are the profit margins of several DeFi blue-chip protocols from January to July 2022.

Take Aave, which has the third largest DeFi TVL, as an example. Although they generated $10.92 million in protocol revenue, they also paid almost $75 million in token emissions, resulting in a loss of $63.96 million, or a -63.1% profit margin.

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LP Gauge Tokenomics

Curve Finance launched the VoteEscrow model, allowing $CRV holders to lock up their tokens to earn $veCRV, granting governance rights to holders and increasing yield.

While this model somewhat offsets short-term sell-offs and encourages long-term participation, it also reduces $CRV liquidity as many tokens are locked (even for up to 4 years).

Instead of locking native tokens, some protocols have built models that focus on locking LP tokens.

LP Gauge economics incentivize liquidity-providing LPs to lock up their LP tokens in exchange for increased rewards and greater governance rights. In this model, traders benefit from a "locked-in" liquidity safety net, LPs gain governance rights and greater rewards, and the ecosystem benefits from deeper liquidity.

One project adopting this model is Balancer, which launched $veBAL tokenomics. Here, users who provide liquidity to the BAL/WETH pool receive $veBAL, which they can lock for up to 1 year. $veBAL holders earn 65% of protocol fees and can vote on pool issuance and other governance proposals.

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Option Liquidity Mining

In addition to "ordinary" liquidity mining, another alternative token model is option liquidity mining. In simple terms, this means that the protocol distributes liquidity incentives in the form of options, rather than native tokens.

A call option is a financial instrument that allows users to purchase an asset at a certain price (strike price) within a specified period of time. If the price of that asset rises, buyers can use their option to buy the asset at a discount and redeem it at a higher price, earning a profit on the difference in price.

Option liquidity mining allows the protocol to distribute liquidity incentives in the form of call options instead of native tokens. This model aims to better align incentives between users and protocols. For users, this model allows them to purchase native tokens at a greater discount in the future. At the same time, protocols benefit from reduced sell pressure and can customize incentives based on their specific goals. For example, create long-term incentives by setting longer expiration dates and/or lower strike prices.

Option liquidity mining provides an innovative alternative to traditional liquidity mining. While this model is still fairly new and untested, there are a few protocols trying to lead the way, one of which is Dopex. They recently announced that they will be testing a call option incentive model for their structured product, which they claim will lead to greater flexibility, price stability, and long-term participation compared to traditional incentive models.

However, there are also concerns that the process will hinder users in general. After all, DeFi has long been dominated by liquidity mining, and introducing these extra steps could deter users and drive them away from a project, especially if they don’t believe the token will actually perform well in the future.

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Berachain

While the above examples provide some interesting models for maintaining liquidity and users, they all focus on the application layer. So what if liquidity incentives are addressed at the consensus layer?

Berachain is a newly launched project that aims to do just that - create a sustainable incentive structure within the chain itself.

It all starts with the “three-token model” — Gas token ($BERA), governance token ($BGT) and native stablecoin ($HONEY).

The novel Proof-of-Liquidity consensus mechanism enables users to participate as validators by staking their assets to Berachain in exchange for block rewards and LP fees.

When users stake their assets, their deposits are automatically paired with $HONEY's native stablecoin on the native AMM. At the same time, governance tokens ($BGT) will also be obtained. $BGT stakers in turn earn protocol fees and have an impact on emissions and other incentives within the ecosystem over time.

In theory, this would create a positive flywheel effect:

• More deposits = deeper stablecoin liquidity;

• Deeper liquidity = more traders will use Berachain;

• More traders = more protocol fees = more rewards for $BGT holders;

• Better $BGT rewards = higher $BGT demand.

This model incentivizes users to keep their assets in the Berachain ecosystem as there are greater earning opportunities than elsewhere. The beauty of this model is that the main beneficiary of the value generated by the chain is the ecosystem itself, rewarding participants for long-term commitment. Users start contributing to the liquidity of the native stablecoin once they make a deposit, thus naturally creating a liquidity mechanism. In addition, users who hold $BERA obtained through block rewards can earn fees generated by on-chain activities by holding $BGT. Protocols may start accumulating $BGT for voting rights, directing incentives towards their specific assets, paving the way for a potential Curve War-like ecosystem to flourish.

Summarize

Summarize

DeFi is still young and primitive, and there is still a lot of work to be done in its current state. Creating a sustainable economic framework is an important part of this process. Arguably, given that liquidity mining is so central to the fundamental nature of DeFi, it's impossible to abandon it altogether.

However, alternative frameworks like those described above demonstrate that a liquidity mining framework can be optimized to maintain liquidity and users, and actually benefit the long-term ecosystem.

Next time you want to get into your favorite DeFi project and look for yield, take the time to understand where the yield is coming from and whether it is sustainable. A little tip: If you don't know where the source of income is, then you are the source of income.