The ICON Defi Guide: Part 10— DeFi 2.0, Protocol Owned Liquidity, and Karma DAO

While the original “DeFi summer” was only a bit more than a year ago, the rapidity of innovation in the crypto space makes it feel like a lifetime ago.

Ever since Compound began offering it’s governance token as an incentive for liquidity providers — the unofficial kickoff of DeFi summer — we’ve seen significant innovations when it comes to entirely new protocols, tokenomic structures, and other DeFi architecture.

Over the past few weeks, we’ve been hearing more and more about “DeFi 2.0.” While some have described this concept as essentially a meme, there is also clearly a bit of a structural shift in the DeFi landscape.

Through the initial phase of DeFi, the term that got used a great deal was “money LEGOs.” Essentially, while each DeFi protocol served it’s own purpose, it could also be used in conjunction with others to further maximize opportunities for users across the crypto space.

This new form of DeFi — which some call DeFi 2.0 — refers to the emerging protocols that are building on top of the “money LEGOs” that were rolled out over the past year. These protocols are helping advance the landscape and have been focusing on how to better incentivize and provide liquidity.

The Liquidity Incentive Problem

As you likely know, nearly every DeFi protocol, including Balanced and OMM, issues “reward tokens” in exchange for providing liquidity to their protocol.

While the idea of distributing governance tokens as a reward for liquidity providers seemed like a good way to align incentives, it became clear over time that this may not be the best model. There are several flaws that are now evident:

First, is the significant sell pressure. A great deal of the LPs who provide liquidity do so on a very temporary basis, and often hop from protocol to protocol, sucking up the juicy mega-yields during their initial days, dumping all their tokens, and then moving all of their liquidity to the next new protocol shortly afterward.

42% of the yield farmers that enter a farm on the day it launches exit within 24 hours. Around 16% leave within 48 hours, and by the third day 70% of these users would have withdrawn from the contract.

Source: Analysis of MasterChef from Nansen.ai

Not only do these mercenary liquidity providers dump their rewards at the first chance, but even those who hang around for a bit longer inevitably dump a vast majority — if not all — of their rewards in order to lock in profit and offset any impermanent loss they may experience as LPs.

The second issue — and its related to what I describe above — is that these reward structures create misaligned goals between the protocol and the liquidity providers. The LPs are incentivized by the high reward rates at the beginning of the protocol’s existence, but not necessarily a strong belief in the long-term success of the protocol.

Of course some LPs will have a long-term interest, but a great majority of the initial liquidity is simply there to grab those juicy initial early rewards.

This ultimately creates somewhat of a negative feedback loop. As the initial liquidity starts to flee, and as the selling pressure continues to pick up, even those who would be long-term believers in the protocol start to lose confidence in the long-term, thus also shifting to a shorter-term mindset, thus dumping their tokens out of fear that they’ll continue to decline in price, which only further drives down the price.

A third problem with the current liquidity model is the impact of impermanent loss. If you’re unfamiliar with impermanent loss (and if you’re far along on your DeFi journey, you hopefully should be familiar), be sure to brush up on the topic here.

As you should know, if someone is providing liquidity and one token experiences a significant rise in price relative to the other, the total value of your liquidity actually goes down.

Now, consider if you’re trying to serve as a liquidity provider with the long-term interest and success of the protocol in mind. If the protocol does do well and the protocol token does do well, it means you essentially lose money! You can see how this becomes a very tricky situation and only further disincentivizes long-term LPs, even if they want to believe in the protocol over the long-term. It only further nudges them toward selling their rewards as soon as they earn them in order to capture profit, only adding further to sell pressure.

The final issue is the fragility of the liquidity.

During a market crash, instances of volatility, or times of uncertainty — those moments when liquidity is needed the most by the protocol — LPs tend to remove their liquidity as they become nervous about the state of the market.

As you can see, put all these factors together, and you get quite the negative feedback loop:

Enter Olympus

By now, you have likely heard of Olympus DAO and/or Olympus Pro.

Olympus DAO was essentially the first protocol to bring the idea of “protocol owned liquidity” to life and it did so utilizing a “bond” mechanism.

The way it works isn’t too complicated. Bonding within Olympus DAO means you trade your LP tokens (remember, when you deposit funds into an AMM, you’re given LP tokens as sort of a “claim” on that liquidity, allowing you to retrieve it at any point) in exchange for discounted OHM (the native token of Olympus DAO).

As a result, Olympus has effectively purchased that liquidity, since it now owns the LP tokens.

Meanwhile, the OHM that was purchased at a discount is vested over a period of five days (accruing 20% of the total each day), making it hard for the purchaser to dump all their tokens at once for a quick profit. In other words, if you trade your LP tokens for 100 discounted OHM, you’ll receive 20 on Day 1, another 20 on Day 2, and so on.

The result of this mechanism has been impressive. As a result of bonding, Olympus has purchased more than 99% of its two main trading pools, OHM-DAI and OHM-FRAX. In other words, it basically owns nearly all of its own liquidity, and isn’t reliant on “renting” it from LPs.

This has provided significant benefit for the Olympus DAO protocol in a few ways.

First, since the protocol owns most of its own liquidity, it’s the beneficiary of nearly all the trading fees. Since it launched the bonding mechanism, the protocol has earned more than $25m in fees, with a vast majority of it earned in just the past couple of months:

Source: Dune Analytics

In addition to the revenue boost, the protocol now has thick liquidity that can’t change based on market conditions. Thus, it’s able to absorb large transactions with minimal slippage. So if someone decides to dump a large amount of the OHM token, there won’t be much impact on price.

For example, the OHM-DAI pool is now the second largest pool on Sushiswap, and it can absorb a trade of more than $5.5m with only ±2% slippage. This helps build confidence in the token.

Those of you who have been paying attention to the BALN market might remember the token hitting $3 in August, only to see a single transaction bring it down to $2.34 in basically an instant:

With more liquidity in place, such a move would be much less likely to happen.

Beyond the benefits described above, there a downstream benefit as well: users can now invest in the long-term success of the project by purchasing the native tokens at a discount and can hold them without fear of liquidity drains, impermanent loss, token dumping, and all the other factors we touched upon.

In addition, under the bonding model, protocols aren’t as reliant on the long-term issuance of liquidity rewards, which are essentially an expense (since they’re used to rent the liquidity). At a certain point, the protocol will have more than enough liquidity, meaning they have the option to taper their purchase of additional liquidity (an expense), while continuing to see ongoing revenue (income) from trading fees. This leads to a healthier balance sheet for the protocol and should theoretically help to build further confidence in the protocol and its governance token.

The model ultimately better aligns the long-term interests of the protocol and the long-term interests of the token holders by building a healthier protocol overall.

Olympus DAO ultimately took this model and realized they could allow other protocols to utilize the bonding mechanism just like Olympus DAO has done. That’s where “Olympus Pro” comes from. They’ve effectively become a bonding “service” for at least twenty other partners. In exchange, Olympus DAO collects a fee of 3.3% on all bond payouts.

By now, you hopefully have a better understanding of all the elements that make Olympus DAO and Olympus Pro tick. So now you have the knowledge necessary to start exploring Karma DAO.

Karma DAO

Karma DAO, which recently won an approval for grant funding via ICON’s Contribution Proposal System (CPS), is looking to build a similar model for ICON’s DeFi protocols.

Based on their proposal, their primary focus will be building out a protocol similar to Olympus PRO, which will offer a bonding service to other protocols operating within the ICON ecosystem.

Right off the bat, we have an immediate benefit to the ecosystem just by the virtue of protocols like OMM, Balanced, and others being able to own their own liquidity, the benefits of which are thoroughly explained above. That part is fairly straightforward.

But what other possibilities does that provide?

What if Balanced offered up it’s holdings of the OMM token in order to acquire some liquidity in the various OMM pairings? What if down the line, OMM wanted to acquire some of BALN liquidity? Karma provides these various protocols with the opportunity to share in the success of one another, further strengthening the ecosystem.

There are also a number of ways this bonding could be funded. For example, SpookySwap, an AMM on the Fantom network, had users vote to allocate a portion of the native $BOO token within the DAO in order to own some of it’s own liquidity.

Alternately, a governance vote could be held to change the emission structure, with a certain % of the native token being dedicated toward bonding and the purchase of liquidity.

It’s ultimately up to the DAO of a given protocol whether or not bonding should occur and how it could be funded, but Karma provides the tool necessary to make it happen.

Ultimately, the eventual launch of Karma DAO will only further strengthen ICON’s DeFi protocols as it helps to continue building out the critical infrastructure that our DeFi ecosystem needs to succeed over the long term.

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ICON contributor and analyst, ready to hyperconnect the world. Twitter: @iconographerICX

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ICONOGRAPHER

ICONOGRAPHER

ICON contributor and analyst, ready to hyperconnect the world. Twitter: @iconographerICX

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