DeFi 2.0 and Liquidity Incentivization

Key takeaways:

  • The DeFi ecosystem’s first “money LEGOs”, such as LP tokens and decentralized stablecoins, set the stage for further DeFi advancements.
  • DeFi 2.0 is a new term in the ecosystem that largely refers to a subset of emerging protocols building on top of the initial money LEGOs to advance the current DeFi landscape, primarily in the form of liquidity provisioning and incentivization. 
  • With the addition of these new financial primitives, the entire DeFi economy is rapidly becoming more user-friendly, secure, and accessible. 

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Decentralized finance, commonly known as DeFi, has been one of the most impactful and successful waves of blockchain-based innovation. Powered by blockchains with built-in smart contract functionality and secure oracle networks like Chainlink, DeFi refers to the wide range of decentralized applications that disintermediate existing traditional financial services and unlock entirely new financial primitives.

Fueled by their inherent advantages of permissionless composability and open-source development culture, DeFi protocols are constantly advancing and iterating upon proven models of financial-based agreements. The DeFi ecosystem moves at a lightning pace—over the past few months, a rising movement of liquidity-focused DeFi projects has brought forth a new wave of DeFi innovation, commonly referred to as DeFi 2.0.

An emerging term within the larger blockchain community, DeFi 2.0 largely refers to a subset of DeFi protocols that are building on top of previous DeFi advancements, such as yield farming, lending, and more. A primary focus of notable DeFi 2.0 protocols is to overcome the liquidity limitations faced by many on-chain protocols that have native tokens. 

This article considers the past innovations that set the stage for the DeFi 2.0 movement and introduces the liquidity problem that DeFi 2.0 protocols are attempting to solve before diving into the utility and new financial paradigms introduced by the DeFi 2.0 ecosystem.

Early DeFi Developments

Early DeFi pioneers such as Uniswap, Bancor, Aave, Compound, MakerDAO, and more have built a solid bedrock for the developing DeFi economy, introducing many crucial and composable “money LEGOs” into the ecosystem.

Uniswap and Bancor were the original decentralized automated market makers (AMMs), the first to offer users the ability to seamlessly swap tokens without giving up custody. Aave and Compound introduced decentralized lending and borrowing, providing on-chain yield for deposits and access to working capital in a permissionless manner. MakerDAO enabled ecosystem users to hold and transact in a decentralized stablecoin, providing a hedge against the volatility of cryptocurrencies.

Through these protocols, users received access to reliable exchanges, frictionless lending/borrowing, and stable pegged currencies—three core financial primitives widely available in traditional financial markets. However, the infrastructure underlying these familiar DeFi-based services differs completely from centralized organizations in terms of transparency and user control. The various technological implementations behind each of these decentralized services serve as the bedrock for DeFi innovations.

Cascading DeFi Innovation

A core example of a blockchain-specific DeFi innovation is Liquidity Provider (LP) tokens in Automated Market Maker (AMM) Decentralized Exchange (DEX) protocols. While DEXs effectively act as an alternative for centralized order-book exchanges, the most popular DEXs employ an AMM model known as a Constant Product Automated Market Maker (CPAMM).

Decentralized liquidity pools in AMMs are used to facilitate token exchanges, in which individual liquidity providers commonly provide equal amounts of each cryptocurrency to contribute to an exchange pair’s liquidity pool. In return, they receive an LP token that represents both their share of the liquidity pool and the fees earned from facilitating swaps.

How AMMs Function
Users receive LP tokens by providing double-sided liquidity to AMM pool contracts.

LP tokens triggered a cascading flow of DeFi innovation, as they were quickly adopted by other DeFi protocols in a multitude of ways. For example, lending protocols such as Aave and Compound iterated on the idea of giving users receipt tokens that represented an underlying deposit, now known as aTokens and cTokens.

The permissionless nature of AMMs and LP tokens also empowered DeFi startups, which no longer had to go through a centralized exchange listing process for their launched tokens. With sufficient liquidity, newly launched tokens could be immediately traded on a DEX. However, without sufficient liquidity, the token exchange function of a DEX becomes limited in utility, with users required to pay astronomical prices for large swaps due to slippage. This led to one of the most prominent problems that currently exists in DeFi: the liquidity problem.

The Liquidity Problem

Liquidity has been a source of frustration for many emerging DeFi projects since the earliest days of the DeFi economy. The entire ecosystem is bootstrapped by tokens, which act as a way for teams to align the incentives of participants, collect rewards from user fees, and become composable with the larger DeFi ecosystem. However, in order to provide users with a robust source of liquidity to trade their tokens on AMM protocols, DeFi teams needed access to a large pool of funds.

A partial answer to this problem was found in third-party liquidity providers on AMM protocols, through which any independent person with sufficient funds could provide liquidity for a token pair. Teams could hypothetically source sufficient liquidity from others, rather than provisioning liquidity by themselves. However, there were few incentives for end-users to bootstrap liquidity for a new token, as this would mean exposing themselves to the risk of impermanent loss in exchange for minimal fee revenue from swaps. They needed a sufficient economic reason to take on that risk.

This led to a chicken and egg problem. Without a sufficient level of liquidity, the slippage induced by swaps discourages users from participating in a DeFi protocol’s ecosystem. Without users participating through token transactions, there isn’t enough fee volume generated to incentivize third-party actors to pool their tokens and provide liquidity.

Chicken and Egg Problem With Low Liquidity Pools Diagram
Low liquidity pools disincentivize new liquidity in a chicken and egg problem.

As a result, another crucial DeFi innovation was born. Rewards based on LP tokens became the primary way of bootstrapping liquidity for new DeFi protocols, a process known as yield farming.

Yield Farming Explained

The advent of yield farming (also known as liquidity mining) caused a surge in DeFi activity in the summer of 2020, known as “DeFi Summer” by blockchain enthusiasts.

The idea behind yield farming is simple. Users provide liquidity for an exchange pair on an AMM protocol, receive an LP token for their trouble, and then stake the LP token for returns that are compensated in a project’s native token. This implementation solved the chicken and egg problem by giving third-party liquidity providers a compelling economic reason to provide liquidity for a token: more yield. In addition to generating greater cumulative fees on AMM swaps, incentivized by deeper liquidity, they could earn further yield by staking and receiving more of the project’s native token.

Diagram of Synthetix Yield Farming Model
Yield farming adds an additional incentive to provide liquidity through native token rewards.

With the introduction of yield farming, new DeFi projects were able to bootstrap sufficient amounts of liquidity to begin and sustain operations, as well as lower slippage for users entering their ecosystem. This led to an exponential rise in the number of DeFi protocols across the board, a testament to the degree that yield farming lowered the barrier to entry for both users and DeFi project founders.

Limitations of Yield Farming

Though highly effective, yield farming does not fully solve the liquidity problem by itself due to the particular limitations of long-term yield farming initiatives. Yield farming excels at bootstrapping initial liquidity, but it must be done with a long-term plan in mind to secure long-lasting, sustainable liquidity. 

This is because of supply dilution, an inherent feature of yield farming. Founding teams distribute native tokens to liquidity providers and provide additional sources of yield, incentivizing liquidity providers to keep their liquidity locked in AMM pools. However, as more tokens are allocated to third-party liquidity providers, an increasing percentage of the total token supply is given to rented liquidity, with liquidity providers able to remove their liquidity at any time and sell their earned LP staking rewards. DeFi teams cannot be certain that liquidity providers will stay if staking rewards dissipate, while keeping staking rewards at high levels for a long period of time increasingly dilutes the native token’s supply.

As projects increasingly look to expand to different cross-chain AMMs and even AMM protocols on the same chain, a variety of yield farming initiatives across different exchanges are required to establish a deep liquidity pool for each. This exacerbates the aforementioned limitation, as emerging DeFi projects must finely balance supply expansion to numerous AMM protocols—often without the manpower, means, or information to do so effectively.

Third-party liquidity providers must be sufficiently incentivized in order to provide liquidity to higher-risk holdings. Because newly launched tokens tend to have high volatility, there is an increased risk of impermanent loss that offsets yields from both trading fees on AMM protocols and yield farming initiatives. This represents a misaligned incentive structure for third-party liquidity providers, who don’t have many options to manage the risk of providing liquidity and yield farming.

Yield farming has served as an impactful way of bootstrapping liquidity for DeFi projects, but it does not come without its longer-term risks. It is both necessary and healthy for most DeFi projects to run yield farming initiatives and bootstrap liquidity, but project teams must be mindful of their token supply and long-term yield farming strategies in order to avoid negative, long-lasting impacts.

DeFi 2.0 and the Quest for Sustainable Liquidity

In the context of liquidity, DeFi 2.0 refers to a few emerging DeFi projects that hope to revolutionize the common problems associated with liquidity provisioning and incentivization. They provide alternatives and supplements to the yield farming model, giving projects a way to source liquidity that can be sustained for the longer term. But how exactly do blockchain-based projects with native tokens maintain a healthy amount of liquidity that’s allocated in an ideal fashion?

OlympusDAO and Protocol-Owned Liquidity

One solution that has risen to the forefront of the DeFi community in 2021 is OlympusDAO’s bonding model, which focuses on Protocol-Owned Liquidity (POL).

Through its bonding model, OlympusDAO flips the script for yield farming on its head. Instead of renting liquidity through yield farming initiatives that expand supply, OlympusDAO uses bonds to exchange LP tokens from third parties for the protocol’s native token at a discount. This provides an advantage to the protocol, and to any project that uses the protocol (e.g. bonding-as-a-service). Through bonds, protocols can buy their own liquidity, removing the potential for liquidity exits and building up a long-lasting pool that can also generate revenue for the protocol.

Diagram of Liquidity Token Bonds
Bonded liquidity is mutually beneficial for both the protocol and its users.

On the other hand, users are incentivized to exchange their LP tokens through bonds because the protocol offers a discount on the token. For example, if the price of token X is $500 with a discount of 10%, the user can bond $450 worth of LP tokens to receive $500 in token X. The result is a net profit of $50, dependent on a short vesting schedule (normally around 5 days to a week) to help prevent arbitrageurs from extracting value.

Another crucial aspect of liquidity-focused bonds is that the bond prices change dynamically and can have a hard cap. This serves an important purpose for the protocol, allowing it to control two levers: the rate at which tokens are exchanged for liquidity and the total amount of liquidity exchanged.

If too many users are purchasing bonds, the discount rate declines and can even become negative, acting as a way to control the rate at which the protocol’s token supply is expanding. The protocol can also determine its desired liquidity amount through a hard cap, in which bonds are no longer available, further controlling supply expansion based on precisely determined parameters.

Realigned Incentives

This multi-faceted model helps to realign incentives between third-party liquidity providers and on-chain protocols. Protocols are better positioned to be exposed to impermanent loss than an independent third-party liquidity provider. While third-party liquidity providers are faced with opportunity costs representing every other liquidity pool and yield farming protocol on the market, protocols have an additional incentive to keep the liquidity as it helps secure low-slippage swaps for users transacting with their native token, lowering the cost of entering their respective ecosystem.

Ultimately, OlympusDAO’s bonding model allows protocols to better mitigate the risk of low liquidity in a long-term, sustainable manner. Combined with yield farming, DeFi protocols now have more tools at their disposal to meticulously plan their growth phases, from initial liquidity bootstrapping to sustainable long-term growth.

Directing Liquidity With Tokemak Reactors

Another liquidity-focused DeFi 2.0 project is Tokemak, a DeFi protocol that seeks to optimize liquidity and liquidity flow. In a nutshell, Tokemak at scale aims to facilitate liquidity through two different parties—the Tokemak protocol and liquidity providers (LPs)—with the goal of efficiently decentralizing liquidity flow through liquidity directors (LDs). 

Here’s how it works. Consider the contents of an LP token. Liquidity providers are required to submit equal amounts of both currencies in a given exchange pair, resulting in impermanent loss as the weights shift and the price changes. To combat this, the Tokemak protocol holds reserves of stablecoins and layer-1 assets that serve as base pairs for emerging tokens. This makes up one side of the liquidity pair. For a Token X-ETH liquidity pool on Uniswap, the Tokemak reserves contribute ETH. 

Independent third-party liquidity providers and DeFi projects can then pool together to make up the Token X side of the liquidity. From there, liquidity directors take the spotlight. Liquidity directors stake Tokemak’s native token to control the liquidity flow, using both of these single-sided liquidity pools to then direct liquidity to a wide range of AMM protocols.

Diagram of Token Reactor model
Token reactors help DeFi projects acquire liquidity and distribute it effectively.

Balancing Liquidity Flow and Direction 

The end result of this system is that liquidity flowing through Tokemak works to meet the goal of efficient, sustainable liquidity direction across the DeFi ecosystem.

Liquidity directors move liquidity based on a voting mechanism, while liquidity providers earn Tokemak’s native token for providing single-sided liquidity. Each party earns variable yield that balances with the other to realize an optimized ratio between liquidity directors and liquidity providers, ensuring that there’s an optimal number of directors for the amount of liquidity provided.

This can benefit emerging DeFi projects—particularly those run by DAOs—as well as yield farmers and liquidity providers. On a base level, Tokemak’s single-sided asset allocation allows DeFi projects to bootstrap initial liquidity solely with their native token without also requiring liquidity for stablecoins and layer-1 assets. Tokemak reactors can also provide a structure for collective decision-making on liquidity flow for DAO-based projects, while simultaneously offering alternative yield options for third-party liquidity providers and yield farmers with mitigated impermanent loss.

Other DeFi 2.0 Advancements

Another subset of DeFi 2.0 protocols is building on top of previous yield generating mechanisms and assets to build novel financial instruments.

A prime example of this is Alchemix, a self-repaying lending platform that has a “no liquidation” design. The protocol lends out representative tokens pegged 1:1 to the collateralized asset. For example, by posting the DAI stablecoin as collateral, users are able to borrow 50% of the amount as alDAI. The underlying collateral is then deposited into yield-generating protocols so that it incrementally increases.

Through the combination of representative tokens and yield-generating collateral, Alchemix can offer a liquidation-free lending platform that enables users to spend and save at the same time—with decreasing loan principal amounts as the collateral continues to garner yield.

Abracadabra, another DeFi 2.0 protocol, employs a similar mechanism, but with a system that’s relatable to MakerDAO. Users can post yield-bearing collateral and receive the MIM stablecoin in exchange, maintaining exposure to the collateral while simultaneously garnering yield and unlocking liquidity for users.

Without the early innovations that first brought the decentralized economy to life—AMM protocols, decentralized stablecoins, and price oracles—there could be no liquidity bonding, liquidity flow mechanisms, or yield-generating collateral. From the early stages of AMM LP tokens and decentralized stablecoins to the DeFi 2.0 protocols of today, every project is a valuable iteration towards building the decentralized economy. 

Chainlink in the DeFi Economy

Another critically important component of DeFi infrastructure is decentralized oracle networks, such as those built on Chainlink. This is because smart contracts, which are the building blocks for all DeFi protocols, are intrinsically unable to connect to real-world data and off-chain computation. Oracles solve this issue by providing the secure off-chain infrastructure necessary for connecting on-chain and off-chain environments. Chainlink Price Feeds are one example, providing access to a secure source of financial market data to enable use cases such as collateralized loans.

Additionally, off-chain computation services powered by oracles such as Chainlink VRF and Chainlink Keepers continue to enable and enhance DeFi protocols across the ecosystem. Verifiable randomness and secure smart contract automation give DeFi developers ready-made infrastructure to power no-loss raffles, automated rebases, limit order functionality, and more.

Chainlink oracle networks provide invaluable services to the DeFi ecosystem’s top protocols. This includes providing price data to determine max loan issuance size and liquidation events in Aave and Compound, automating key functionalities in Bancor’s improved v3 AMM implementation, and helping secure the exchange of crypto-based financial products within the L2-based dYdX protocol.

DeFi 2.0 protocols are no different. Given the rise of cutting-edge DeFi 2.0 protocols and liquidity solutions, listed below are a few examples of how Chainlink services can be used to level up these new categories of liquidity solutions and help them offer secure, user-friendly products.

Reliable and Transparent Asset Pricing 

By deploying multiple layers of aggregation to decentralize the sourcing and delivery of off-chain data, Chainlink Price Feeds help ensure DeFi products that require financial market data are protected against market volatility and unexpected events such as flash crashes, exchange downtime, and price manipulation attacks via flash loans.

For example, Chainlink Price Feeds can provide additional security and accuracy to liquidity bond prices by providing real-time information regarding the current price of an LP token. Liquidity bonding protocols can leverage this data to increase the reliability of bond payouts and even extend the utility of liquidity bonds—from powering secondary bond markets to enabling additional incentives for bonding reliant on the current bond price. 

For yield-generating collateral mechanisms, Chainlink Price Feeds enable tamper-proof pricing when using yield-generating tokens as collateral, helping ensure accurate calculations for collateral requirements and liquidation thresholds.

Automated Rebasing and Liquidity Cycles

Chainlink Keepers—a secure, decentralized smart contract automation service—can offload and automate manual smart contract DevOps processes. This enables developers to focus on building and refining their application’s core business logic.

In a DeFi 2.0 context, this can take the form of automatically rebasing representative tokens based on underlying supply changes. Chainlink Keepers can also be used to jumpstart new governance procedures for liquidity direction on a regular basis, giving users more predictability and reliability in smart contract services.

Verifiably Random Gamification

A growing trend for DeFi protocols and blockchain-based protocols at large is gamification. Unbiased entropic elements make DeFi protocols more exciting and engaging, helping bring together communities. Auditable on-chain randomness through Chainlink VRF can be a powerful tool that offers users multiple yield generation avenues based on risk preference.

OlympusDAO currently uses PoolTogether and Chainlink VRF to run its (3,3) no-loss raffle, which takes all staking rewards in the pool and selects three winners to receive the total reward in a verifiably random manner. A similar process can be applied to yield generation on liquidity provisioning, with liquidity providers also able to deposit their yields and enter no-loss raffle games. Additionally, as DeFi 2.0 projects and beyond look to leverage NFTs, Chainlink VRF also provides a tamper-proof way to build randomized minting processes, fair distribution models, and more.

Chainlink decentralized oracle networks provide a wide range of off-chain data and computation services that are increasingly relevant for any blockchain-based project that wishes to keep up with the rapid pace of smart contract innovation—another example of a foundational money LEGO in the DeFi ecosystem.

Money LEGOs in DeFi

Money LEGOs are a useful analogy when conceptualizing how the DeFi economy moves as a unit. Cutting-edge innovations and new technologies can be combined, with each piece building on top of another, leading to the creation of something greater than the sum of its parts.

DEXs and LP tokens are one of the blockchain industry’s most prominent money LEGOs, enabling the on-chain exchange of tokens at scale and making yield farming possible. The initial wave of decentralized stablecoins set the stage for both newer stablecoin designs and decentralized lending platforms through airtight overcollateralization processes and risk mitigation. Chainlink’s off-chain data and computation services have provided the underlying infrastructure required by countless DeFi applications, helping make these innovations possible.

None of these money LEGOs can be considered in a vacuum, but should be thought of as an interconnected ecosystem that supports, connects, and accentuates other building blocks to create new possibilities. By combining Chainlink Price Feeds and AMM LP tokens, dynamic yield farming initiatives were made viable. Through the integration of stablecoins into AMMs, users were granted the stability needed to transact solely on decentralized exchanges.

With DeFi 2.0, a new generation of money LEGOs is being built on top of its predecessor to make the decentralized finance landscape more efficient, user-friendly, and useful for its participants. The money LEGOs continue to stack—and with each additional block comes new value and opportunity for the DeFi ecosystem.


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