Since 2020, decentralized finance (DeFi) has grown incredibly quickly and has the potential to upend conventional finance.
The rise of DEXs in particular brought forth important advancements that made it possible to support trading without a centralized intermediary by using an Automated Market Maker (AMM), liquidity pools, and liquidity providers.
These advances do have certain disadvantages, though. In particular, the mercenary liquidity issue affects protocols, which frequently need to offer generous rewards to liquidity providers to supply liquidity to allow trade of their token.
In this context, protocol owned liquidity, a novel method of supplying tokens on DEXs with liquidity, emerged. In addition to promising to tackle the mercenary liquidity issue, this Olympus DAO concept also aims to establish a reserve currency.
What is protocol owned liquidity?
Protocol owned liquidity, which has been developed by Olympus DAO, is a novel method for giving tokens on decentralized exchanges liquidity. The protocol owned liquidity model uses a “bonding” mechanism rather than depending on giving the market incentives to deliver liquidity to liquidity pools.
In essence, bonding entails the protocol offering discounted tokens to customers in return for another token (such as DAI), which serves as a reserve for the protocol. The treasury can then be used to directly supply liquidity to DEXs (earning trading commissions) and invested to produce returns.
Protocol-owned liquidity is a brilliant solution to the mercenary capital problem, in which protocols engage in a “race to the bottom” to provide greater and higher incentives to attract liquidity providers, hence diminishing the value of the protocols through increased token issuance.
Protocol owned liquidity is likely to remain a feature of the DeFi landscape, with protocols trading on DEXs using a combination of the protocol owned liquidity model and traditional liquidity pools.
Describe Olympus DAO.
The goal of the Olympus DAO project is to establish decentralized assets like DAI and FRAX as the underlying assets for a reserve currency for the DeFi market. The Ethereum ecosystem depends on stablecoins that are backed by US dollars, which undermines the value of decentralization. As a result, the project is now developing OHM, a new stablecoin, as a reserve currency. The DeFi 1.0 protocols, particularly AMMs, suffer from the mercenary capital problem as a result of their attempts to reward users with trading commissions and tokens from liquidity providers.
OHM is therefore a “secured” cryptocurrency rather than a “pegged” one. It is backed by a variety of assets and is not tied to the US dollar. Additionally, Olympus DAO thinks that OHM will be able to retain its protocol-controlled value even in the face of market volatility by concentrating on supply rather than pricing.
The benefit of protocol-owned liquidity
Protocol-owned liquidity programs, invented by Olympus DAO, use a bonding mechanism. This indicates that the protocol offers a discount on its tokens in return for users contributing another token. Since the DAO or organization controls the liquidity, there is more congruence between the aims of the project and the liquidity providers.
The organization now in charge of the firm, exists. In the ensuing years, the decentralized autonomous organization (DAO) would finally swallow the whole company.
Users that provide liquidity to the BNB-RADAR pool will be compensated with Liquidity Pool (LP) tokens. They can then use those LP tokens to buy an ApeSwap RADAR Jungle Bill. To put it simply, this enables consumers to receive a bonus.
It’s time to take tokenomics and liquidity provision more seriously now that yield farming is gone. A natural development that will improve protocols and DAOs is protocol-owned liquidity. As a mechanism to improve liquidity and reward the community, protocol-owned liquidity is undoubtedly here to stay.
A pool of miners may get compensation from a token issuer or exchange for supplying liquidity for a particular token. On the Compound system, for instance, users who deposit tokens will get interest and a portion of the COMP governance token.
DeFi protocols encourage customers who deposit cryptocurrency assets on the platform since they need to increase liquidity. Profit farming is the practice of increasing compensation for supplying liquidity on DeFi platforms.
Why Web3 projects should move to protocol owned liquidity?
Problem: Mercenary liquidity
Starting a project on Web3 presents a number of problems. User acquisition, onboarding, design, and actual functioning are all included. However, there is an extra degree of complication in Web3: tokenomics and liquidity.
Many blockchain projects, such as Ethereum, Polygon, and BNB Chain, have their own cryptocurrency as a token. However, the financial liquidity required to trade these tokens is frequently provided by either investors or the community. Hundreds of protocols have started liquidity mining activities in an attempt to build a large liquidity pool.
But typically, this is Mercenary liquidity. The incentives from these projects are frequently dumped on the market, driving down the token’s value. Furthermore, a liquidity pool may quickly run dry after the liquidity mining campaign is through. Investors will search for their next farming endeavors. Yield farming has become a huge challenge for new methods, and for good reason.
We have a different option with protocol-owned liquidity that makes the protocol stronger.
Solution: Protocol Owned Liquidity
The protocol owned liquidity approach, developed by Olympus DAO, offers a potential solution to the mercenary liquidity issue. Bypassing the requirement for external liquidity providers, protocol-owned liquidity results in the protocol itself supplying liquidity to its own trading pair on DEXs. The “bonding process” is the main invention that makes this possible.
What is bonding?
The bonding process entails the protocol selling their own token (for example, OHM) in exchange for another token (for example, ETH or DAI) or a liquidity pool token (for example, OHM/ETH) from a buyer. The protocol incentivizes the buyer to bond (rather than buy tokens on-market) by selling their token at a discount (usually 5-10%) to the current market price, which is vested over a period (often less than a week) to prevent an immediate arbitrage opportunity.
The protocols end up holding a lot of valuable tokens in their treasury as a result of the bonding process. This approach can be compared to how a reserve bank would sell the currency they control in their nation to acquire a foreign currency on the open market and then hold that foreign cash in their treasury.
What are protocols supposed to do with the treasury’s tokens?
The protocol makes use of the tokens obtained through the bonding procedure as follows:
Offer liquidity to liquidity pools on DEXs for their own token (for instance, Olympus DAO would operate as the liquidity provider and offer ETH and OHM to the ETH-OHM pair on Uniswap), receiving the transaction fees in the process.
Tokens should be invested for a profit (e.g., lending the tokens, investing in a protocol project)
Creating a reserve currency
The fact that the protocol now has valuable tokens in its treasury makes it appear as though the protocol is “backed” by assets, which is a byproduct of the protocol controlled liquidity model. Theoretically, this could set a price floor for the token (for instance, if the Treasury owns $1 billion USD worth of ETH, the Protocol’s minimum market capitalization should be $1 billion USD) and give the Treasury the ability to “defend” the price of their token by purchasing tokens on the open market (pushing the price up).
This claim should be treated with suspicion because the protocol will continue to supply liquidity to the tokens’ DEX liquidity pools. As the protocol would add more reserves assets to the trading pair, if there is persistent selling of their token, this will deplete the Treasury of their reserve assets, lowering the price floor. Selling can lower the price floor, which encourages further selling, creating a negative feedback loop. Though it should be noted that the protocol might choose to remove liquidity from its liquidity pairings, doing so would essentially undermine the fundamental idea of a protocol-owned liquidity model.
Offering high staking APYs (sometimes greater than 1000%) to lessen the temptation to sell, Olympus DAO and other forks have partially incorporated methods to decrease this risk (utilising the classic prisoners dilemma argument in game theory). It is unclear whether this APY inducement will last in the long run, underscoring the requirement for protocols to develop a distinct value proposition for users in order to uphold trust in the token as a reserve currency.
Noting nevertheless that protocols do not need or want to generate a reserve currency, they can still use the protocol owned liquidity model.
Liquidity-as-a-service (LaaS) (LaaS)
The idea of LaaS, introduced through the Olympus Pro platform, may be a more durable legacy of Olympus DAO. As a result, protocols can use the protocol owned liquidity model with ease.
Users can buy bonds using the platform’s bond marketplace by selecting them from the available protocols (paying Olympus DAO a transaction fee).
These types of marketplaces should make it less difficult to issue bonds by connecting protocols with capital providers, which will promote the use of this model in DeFi.
The DeFi ecosystem will continue to benefit from the protocol-controlled liquidity that Olympus DAO introduced. Some people question if discounting bonds would result in the same problems as incentives in DeFi 1.0 or whether Olympus DAO has an excessive advantage over rivals. Whatever the case, future DeFi protocols are expected to combine protocol-owned liquidity with conventional LPs.