Generating liquidity in DeFi 1.0
New DeFi projects and protocols that issue their own native tokens need to create liquidity around them to broaden market interest and raise capital. The most common strategy is to use liquidity mining as a rewards program for early adopters. The idea is that a user provides an even amount for each token in a trading pair. Afterwards, they can stake the Liquidity Provider (LP) tokens for high Annual Percentage Yields (APY), paid out in the native newly issued token.
As the APY rewards generated use newly minted tokens, liquidity mining increases the supply of the token. And as basic economics entail, increasing token supply tends to lower the trading price of the token. Adding to that, the APY usually starts off astronomically high, only to drop rapidly by the hour as more liquidity providers join the pool.
Consequently, liquidity mining is often only temporarily attractive for users. According to nansen.ai on the loyalty of users in popular yield farming contracts, only 25% of users stay longer than 30 days on the same contract. And the behaviour makes sense once you consider that the newly minted coins are often quick to sell as users try their best to avoid impermanent loss – that moment when money is lost due to the depreciation or reduced opportunity cost of assets that are locked in pools. Some protocols put in place vesting periods to lock in liquidity, but this only postpones the same issue.
This translates to a system that is not very sustainable in the long run. Liquidity is therefore one of the key issues DeFi 2.0 aims to solve.
What is DeFi 2.0?
DeFi 2.0 is the 2nd generation of projects and protocols developing ways to solve the liquidity mining problem, like the Liquidity as a Service (LaaS) model, or separating liquid asset contributions from volatile tokens in a bid to eliminate impermanent loss. Let’s look at a few of these DeFi 2.0 projects to understand how the new liquidity model works.
OlympusDao is an algorithmic currency protocol that aims to become a stable crypto-native currency. While it sounds like another algorithmic stablecoin, the project ecosystem operates more like a central bank since it uses reserve assets like DAI stablecoin to manage its price.
The goal of this DeFi 2.0 project is to achieve price stability while maintaining a floating market-driven price. The biggest difference between OHM and stablecoins like USDC is that OHM is backed – but not pegged – to a certain price. This mechanism is similar to FEI, but the key difference is that FEI maintains a 1:1 peg to the US dollar, while Olympus allows its token to float.
Users can stake OHM, which reduces the circulating supply, while using the newly-acquired liquid assets to mint corresponding new OHM tokens and to reward stakers. The tokenomics were designed to encourage users to keep staking and to keep providing liquidity instead of dumping the token.
Tokemak (TOKE) is DeFi 2.0 project which offers a single-side staking solution that accepts ETH and USDC staking. The protocol then deploys these assets in voting pools, where TOKE is paired with other volatile tokens selected by TOKE holders. These are supposed to offset any effects of impermanent loss for liquidity providers by distributing the fees the protocol earns and the remaining yields according to token emissions.
New TOKE tokens are minted if fees fail to cover impermanent loss, placing responsibility on the TOKE DAO community. DeFi projects going live can generate liquidity for their newly issued native token by activating a TOKE pool and providing initial liquidity to the pool.
This DeFi 2.0 project is using another model to offset impermanent loss, incentivizing liquidity providers to take long-term positions. Ondo Finance gives users the choice between downside protections and enhanced returns, splitting pools and LP assets into multiple investment classes: A primary asset that receives a fixed yield and a volatile asset with a variable but higher APY, both with compounding by default. The liquid asset’s yield is prioritized, impermanent loss is negated, and all the remaining yields go to volatile asset contributors.
What’s in store for DeFi 2.0?
It’s too soon to tell what other projects will come from the DeFi 2.0 development. While liquidity is a major issue that needs to be improved, it is certainly not the only aspect. Thanks to the interoperability of the DeFi ecosystem, we already have incredibly complex solutions and products that build on other protocols through mechanisms like auto-compounding, reward token recycling, and even complex cross-chain yield optimization. These complex solutions are used to generate maximum yields.
Thanks to the modular design of DeFi, improved functionalities in new protocols do not necessarily mean existing protocols lose market share. If anything, DeFi 2.0 will only attract more total value locked (TVL) across DeFi.
DeFi’s sizzling hot boom started years ago, but the heatwave it is riding on is long from over.