R.I.P. Liquidity Mining

Liquidity Mining Obituary

June 16th, 2020 - October 19th, 2022

Liquidity mining is the mechanism used to incentivize users to lend liquidity with a reward token. TapiocaDAO today officially announces the death of Liquidity Mining. We offer a novel and brand new monetary policy to DeFi featuring sustainability, permanent value capture, and financial alignment of invested participants. We consider this to be the liquidity incentive trilemma that TapiocaDAO has solved with DSO, or DAO Share Options. We invite you to read Liquidity Mining’s obituary below, and the details surrounding this paradigm shifting mechanic.

Liquidity Mining unofficially began on June 16th, 2020 with the decentralized lending and borrowing protocol, Compound. Participants who either borrowed or lent to the Compound protocol were rewarded with COMP tokens. These tokens were used to increase returns for lenders and subsidize interest rates for borrowers.

Compound’s “TVL,” or total value locked, instantly rose 600% with the launch of its liquidity mining program. However, there was an unintended deleterious effect on Compound's meteoric rise. Very few of these “miners” actually ended up holding their emitted COMP tokens. According to the report, only 19% of the accounts kept more than 1% of the COMP they claimed, dumping 99% of their liquidity incentives on the market. Did these recipients retain any economic interest in Compound? No.

Secondarily, Compound’s cost of renting liquidity in the form of minting and circulating new tokens, versus the revenue that the rented liquidity generates generally results in large operating losses. Operating Loss in this case refers to the protocol’s operating expenses (in emitting reward tokens) vs revenues (fees). This is the primary harmful effect besides the harsh dilution COMP token holders face from these emissions.

As evidenced in the graphic above, almost all of DeFi is extremely unprofitable. This isn’t because there isn’t sufficient revenue generation. DeFi protocols generate relatively large revenue(s). For example, AAVE generated $101.4m in revenue annualized. The problem may appear to start with 90% of its revenue being distributed to lenders, leaving the protocol margin at around 10% or $10.92m, but this isn’t the core issue. There are still millions of dollars in revenue for the protocol itself. The problem lies squarely in liquidity mining’s hands. AAVE paid out $74m in incentives to rent liquidity, creating a net loss of $63.96m for one of the largest protocols in DeFi. Did AAVE need to give out AAVE tokens to LPs for $0? No, but here we are.

However, glaringly standing alone in profitability is Maker. Generating $28.61M in total revenue, which was all accrued to the DAO. This is due to there being no reward token with dividend payouts. This proves not every protocol needs a token. Many DeFi aficionados’ palettes are so accustomed to protocols treating emissions like Jerome Powell with a magical money printer that they prefer when protocols instead don’t even offer a token. No reward token, no operating loss, no dilution. But it is undeniable that a carefully gamified and well-balanced token economy can create lightning in a bottle.

Some of our dear readers may say, “these incentive programs attract liquidity, so why’s it bad?” “Liquidity is King”. What is actually being attracted is not liquidity but liquidity locusts; non-loyal “farmers” who take their rewards and leave for the next geyser of tokens or when the current one runs dry. Compound now cannot even close the liquidity mining spigot due to liquidity locusts using the single utility many liquidity mining token rewards offer- governance. This creates a deep misalignment of financially invested participants inside a token economy of loyal token holders who actually contribute to the growth of the protocol vs. yield farmers who want the max return at any cost from whoever will provide it. They will vote to continue reaping the maximum amount of benefit, and it’s all our fault.

Compound did not originate the Liquidity Mining idea (or even liquidity mining in smart contracts, that honor goes to Synthetix for its “StakingRewards” contract that was co-authored by Anton of 1inch). Liquidity mining, like many things, was an old idea with a new name. The concept of liquidity mining in cryptocurrency traces back to FCoin, best known for crippling the Ethereum network in 2018. FCoin was actually the first cryptocurrency product to offer something akin to the concept of liquidity mining that we’ve all come to know, in what FCoin called “Trans Fee Mining”. (bad name, huh?)

The founder of FCoin was none other than Jian Zhang, ex-CTO of Huobi. FCoin offered large token incentives to its traders, hoping that the liquidity this created would attract organic growth in user count. FCoin essentially was making a bet that users would stay on the exchange after the liquidity incentive program ended. Hint: They didn’t.

Once a token model has an acceptable liquidity incentive design, it also requires a sound monetary policy; addressing token supply (dilution), token demand, token circulation, etc. This is critical because it will affect the token price and the token price will impact the effectiveness of an incentive program, and the incentive program affects how much liquidity the protocol can draw into its grasp.

What is the current goal of liquidity mining? To rent liquidity. Let’s pose a question: Would you rather receive $1,000,000 USD or $100,000 USD? If you answered “The $1,000,000, of course,” you, like virtually every DeFi protocol in existence, did not properly assess this question. How long do you get custody of that $1,000,000? Inquiring further with time in mind exposes details critical to correctly assessing the true value being offered; if the question now changes to “Would you rather receive $1,000,000 USD for one second, versus $100,000 USD for a year,” your answer would now most likely be different to the option you previously selected. You can do very little with a million dollars in a second, but you can do a lot with $100k in a year; this is no different for a protocol.

These “liquidity rental incentive programs,” which attract liquidity locusts, are completely unsustainable and completely ineffective in their core goal. In a study by Nansen; “A whopping 42% of yield farmers that enter a farm on the day it launches exit within 24 hours. By the third day, 70% of these users had withdrawn from the contract and never returned.”

Based on this data, liquidity locusts are entering positions only to maximize their returns, and no true long-term value is created for the protocol besides fee revenue that is microscopic when compared to the cost of incentivizing liquidity in the first place. To motivate these actors in liquidity mining programs, protocols generally allocate large percentages of their token supplies toward keeping payments going to liquidity providers (see, the mafia), as they have no loyalty to the protocol itself, and only are there to extract value. That is, these token rewards are nothing more than mafia protection payments, “as long as you keep paying me, you’ll keep your big number on DefiLlama, capiche?.” At the end of the day, what does the protocol actually own from liquidity mining? Absolutely nothing. As soon as the protocol stops paying out, the liquidity is as good as gone.

Whoever controls liquidity controls DeFi

Enter Olympus

Olympus looked at this broken model, and rather than try to create a model that could perpetually pay for rented liquidity (see, impossible), Olympus, (correctly) seeing that a protocol should create permenant value for itself and grow its balance sheet, drew on the demand for their OHM token to create POL or “Protocol Owned Liquidity”. They were the first to realize you don’t need to negotiate with the liquidity provider mafia. You can instead beat them at their own game and create permanent value for the DAO’s balance sheet through gamification; trick the mafia into thinking it’s winning.

While some may say Olympus was a failed experiment, Olympus was the first to exit the hostage negotiation of continually paying for rented liquidity. POL became a fixture of the “DeFi 2.0” landscape. So why did Olympus “fail” if it was successful in at least identifying the critical monetary policy oversight in DeFi, the lack of real value creation? The 3,3 mechanism like all other liquidity mining programs inflated the OHM bubble with illogically high yields (remember: if you don’t know where the yield is coming from, you are the yield). 

Eventually, the financial misalignment of participants reached critical mass, yield farmers who controlled the majority of the OHM supply felt they had extracted as much value as they could, exited, and the price of OHM entered a death spiral. Olympus panicked and offered inverse bonding. Inverse bonding allowed users to sell their OHM tokens back for the POL assets. This lost OHM’s POL (the only real value it created), undiversified the treasury, and lowered investor confidence. Redacted was the only winning participant of Olympus, as it pivoted once the dilution got too high, keeping the POL.

Even if you dear reader opines that Olympus “failed,” the baby should not be thrown out with the bathwater regarding Olympus and POL. 

Enter ve

ve, or “vote escrowing” was pioneered by Curve with veCRV. Curve paid close attention to protocol loyalty, and required lockup of their liquidity rewards in order for prospective liquidity providers to maximize their returns from their liquidity incentive program. Curve essentially created a tiered incentive structure; the more loyal you are to Curve, the more rewards you will receive. 

While the inclusion of loyalty into the equation (now liquidity lent + time) greatly heightens Curve’s ability to keep financial participants aligned and to create more loyal protocol users. The problem still remains that Curve owns no liquidity; investors still are diluted by emissions, and liquidity locusts are still able to get something valuable (CRV) for next to nothing (supplying liquidity that can be pulled at any time). Imagine the amount of POL Curve would create if it wanted to, value all left on the table, that’s value Tapioca can instead capture as it’s been left ripe for the snatching.

When the value of CRV goes down, CRV incentives are less valuable, and therefore the direction of these emissions becomes much less valuable. Protocols war over veCRV in the Curve Wars, which created “incentive-ception”; Protocol X mints and circulates their tokens in an incentive program to own veCRV and thereby direct the CRV incentives. This is a great mechanism, but as a protocol you have done little more than diluting your shareholders via minting new tokens to capture the veCRV, an illiquid asset. Add in Redacted and Convex, you have an inception of an inception. These features should've been built into Curve natively from the start. ve inefficiency has quite literally spawned an entire industry. You may capture more liquidity with veCRV incentives than by incentivizing liquidity with your own token, why not increase the value of your own incentives instead?

Not to pile on Curve, as ve is quite obviously the best staking methodology ever created due to the financial participant alignment, but the Curve War at a protocol level is somewhat of an illusion. As a protocol, why give up your valuable assets to acquire an illiquid asset that may or may not have valuable incentives at any given time? Like Yearn, Badger, and StakeDAO, offering services to rent veCRV is far more attractive- exploit its inherent value while the value exists. Attract liquidity with the “rented” veCRV, and permanently trap in as much of the liquidity that veCRV incentivizes to the protocol as possible.

Lastly, with Curve, the one way it’s created permanent liquidity is through becoming a part of the mafia. Protocols need Curve to stabilize their stablecoins, not to earn fees. What if instead of trying to rent more liquidity, you used the fee generation from Curve pools to simply own more liquidity? This is precisely what Tapioca is doing. We have exited the matrix, accepted the red pill, and seek to own the only thing that’s real in DeFi- liquidity. Or you can take the blue pill and pretend by gamifying these mechanisms “just a bit more” that you can inflate perpetually to incentivize liquidity. I will show you how deep the rabbit hole goes, Neo.

Enter Andre Cronje

Before Andre created Solidly Exchange and ve3,3, which tried to remove dilution from the list of problems ever present in ve liquidity mining. Andre created OLM, Options Liquidity Mining, for the experimental automation network, Keep3r Network.

Andre (in usual Andre fashion) had the start of something that would later revolutionize DeFi. If you provide liquidity to Curve, and you claim CRV as your liquidity mining reward, what actually just occurred? The liquidity provider exercised a CRV call option with a strike price of $0, and no expiry. When you start thinking of emissions in liquidity mining programs in terms of American style call options, all of a sudden protocols have the power they didn’t have before.

The problem with Andre’s OLM was that the protocol still created no POL. The redemption of the options is the key to DSO. oKP3R distributed the option redemptions to vKP3R lockers- a nobel and simplistic way to incentivize lockup. But again we come back to the central question, “why are we incentivizing liquidity to our protocols in the first place?” To generate sufficient liquidity depth to sustain the protocol’s core functions, but the point of these services is to generate revenue to sustain the organization as a whole. By owning your own liquidity, you don’t need to incentivize it anymore. You take the red optionalized red pill, and exit the liquidity mining Matrix.

Turn off the money printer 

SIP-276, a Synthetix Improvement Proposal authored by Kain Warwick addressed the insanity of the heavy inflation occurring in the DeFi Summer protocols that have made it from the bear to the bull and back to the bear. These protocols had heavily incentivized (rented) liquidity, and Synthetix wanted to (again as usual) be first in putting its foot down to inflating the supply further. Synthetix felt it had successfully bootstrapped its ecosystem, which is hard to argue with when its revenue generation at times surpasses Ethereum.

As Compound saw, turning these rewards off can be very difficult as mercenary liquidity providers generally control governance. If it were to pass, being rented liquidity, the liquidity could (and probably would) immediately leave the protocol, fees would go down due to less liquidity depth, and it would be difficult to sustain the ecosystem moving forward. While Tapioca will move on a similar path, Tapioca will seek to instead acquire as much POL as possible during carefully pre-calculated inflation. Once the supply has hit its predefined apex, the protocol would instead be sustained off its own POL. The fees and yield on this POL would flywheel itself (Obtain POL > Create Yield on POL > Acquire More POL > Rinse Repeat). Tapioca would be able to carefully inflate the supply of TAP to a predefined level using American options that in themselves create permanent value.

POL + Options = DSO

With Tapioca, there’s no free lunch. Lenders will receive an option to buy at a discount- a DAO Share Option (doesn’t that make so much sense?). To get value, you have to give value, and the protocol now can now properly quantify that value. Taking the core concept from Olympus; a successful model must trap value as long as possible, not just get big TVL numbers on DefiLlama. Therein, TIME is the missing quantity in sound DeFi protocol monetary policy in regard to incentivizing liquidity. (don’t worry, not the Wonderland sort of time). The longer the liquidity is locked, the more total yield will be generated, thus the more revenue is generated for the protocol, the more POL is created, the better the DAO’s balance sheet looks.

Firstly, the option being exercised would purchase TAP from the Tapioca DAO at a discount. The discount is based on the time investment of the lender. This redemption generates liquidity, the lender can still sell the TAP for a guaranteed profit. However, the protocol now wins, investors win, and the liquidity provider wins- we now have a harmonious “throuple” relationship even Charlie Sheen would approve of.

1. The lender can lock in a guaranteed profit on TAP, that profit is correlated to the amount of quantifiable value the DAO receives from the lender (liquidity amount + time investment = value proposition the lender is offering).

2. Investors win because there’s a price floor set via options expiries (lender(s) can’t hold these options forever, they expire. veTAP Lockers get more protocol revenue due to the options being redeemed.

3. The protocol creates POL from option redemptions- no rentals but permanently owned liquidity. Lenders have to lock liquidity longer to get deeper discounts, creating more fees (thus also PCV) with semi-forced loyalty to the protocol a la Curve. This also stabilizes the protocol ecosystem as liquidity cannot be pulled at any moment.

4. veTAP is used just like veCRV as a tiered incentive system, the more veTAP you have, the deeper you can boost your option discount, to a max of 75%.

5. Liquidity locusts are still incentivized to lend liquidity, but there’s no real way for them to extract value from investor’s shares without giving value back.

At its most basic level, DAO Share Options or DSO is simply saying, the expiry = one week, and for example, if locking their liquidity for 16 weeks offered a 50% discount, that’d mean the strike price = TAP spot price - 50%.

Let’s say this liquidity miner, mined 100 TAP; instead of simply receiving the TAP CALL option at a strike price of $0 and expiry now (100 TAP tokens for free, like current liquidity mining), with DSO instead they would receive the right to purchase 100 TAP for $100 (if TAP = $2). Even if they are a liquidity locust, they would still be incentivized to do this, since they still make $100 profit (trading 100 TAP @ $2 = $200 - $100 purchase). There’s actually even more incentive as with how unsustainable DeFi protocols have gotten, sometimes these liquidity-mined tokens are worthless anyway. With DSO, the liquidity provider is guaranteed to make a profit.

The “profits” ($100 in the above example), can now be distributed to veTAP holders and or go to the DAO, creating permanent liquidity. These treasury funds can now be used to provide liquidity for usd0 and TAP, creating a self-sustaining and growing ecosystem that cannot be toppled by a bank run.

To take this one step further, and take the expiry of one week, now for argument’s sake, we’ll say liquidity locusts were receiving options and exercising them and dumping directly after. Let’s say this has decreased the price of TAP from $2 to $1. One week later, the liquidity locust goes to exercise and dump their oTAP options, there’s a problem. The TAP call option price was also $1, so at this point, there is no reason for the “dumper” to claim the option anymore since they wouldn’t make any profit. This means that DSO has set a price floor, and no additional TAP will be circulated as the option will not be redeemed, stopping dilution. You don’t give value, you don’t get value.

The central goal of Tapioca is to become the cross-chain banking layer, the ultimate hub of DAO-owned liquidity for all of DeFi across 12 EVM compliant networks. Tapioca will capture all of the liquidity that comes in proximity with it, forever. DSO is but one of many innovations Tapioca offers to change the landscape of DeFi forever.

Join us, anon.